Federal Grid Company of Unified Energy System (MCX:FEES) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Public Joint-Stock Company Federal Grid Company of Unified Energy System (MCX:FEES) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Federal Grid Company of Unified Energy System

What Is Federal Grid Company of Unified Energy System's Net Debt?

As you can see below, Federal Grid Company of Unified Energy System had ₽221.9b of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of ₽57.6b, its net debt is less, at about ₽164.4b.

A Look At Federal Grid Company of Unified Energy System's Liabilities

We can see from the most recent balance sheet that Federal Grid Company of Unified Energy System had liabilities of ₽67.6b falling due within a year, and liabilities of ₽306.3b due beyond that. Offsetting this, it had ₽57.6b in cash and ₽52.8b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₽263.5b.

When you consider that this deficiency exceeds the company's ₽254.3b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Federal Grid Company of Unified Energy System has a low net debt to EBITDA ratio of only 1.2. And its EBIT covers its interest expense a whopping 2k times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Federal Grid Company of Unified Energy System saw its EBIT drop by 8.2% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Federal Grid Company of Unified Energy System can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Federal Grid Company of Unified Energy System recorded free cash flow of 40% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Neither Federal Grid Company of Unified Energy System's ability to handle its total liabilities nor its EBIT growth rate gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We should also note that Electric Utilities industry companies like Federal Grid Company of Unified Energy System commonly do use debt without problems. Taking the abovementioned factors together we do think Federal Grid Company of Unified Energy System's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider risks, for instance. Every company has them, and we've spotted 1 warning sign for Federal Grid Company of Unified Energy System you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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