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

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Public Joint-Stock Company Federal Grid Company of Unified Energy System (MCX:FEES) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, 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?

The chart below, which you can click on for greater detail, shows that Federal Grid Company of Unified Energy System had ₽229.6b in debt in September 2021; about the same as the year before. However, it does have ₽63.4b in cash offsetting this, leading to net debt of about ₽166.2b.

How Healthy Is Federal Grid Company of Unified Energy System's Balance Sheet?

The latest balance sheet data shows that Federal Grid Company of Unified Energy System had liabilities of ₽72.2b due within a year, and liabilities of ₽324.9b falling due after that. Offsetting these obligations, it had cash of ₽63.4b as well as receivables valued at ₽41.7b due within 12 months. So its liabilities total ₽292.0b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's ₽206.0b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Federal Grid Company of Unified Energy System has net debt of just 1.4 times EBITDA, suggesting it could ramp leverage without breaking a sweat. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. On the other hand, Federal Grid Company of Unified Energy System's EBIT dived 19%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Federal Grid Company of Unified Energy System's free cash flow amounted to 37% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

To be frank both Federal Grid Company of Unified Energy System's level of total liabilities and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. We should also note that Electric Utilities industry companies like Federal Grid Company of Unified Energy System commonly do use debt without problems. Looking at the bigger picture, it seems clear to us that Federal Grid Company of Unified Energy System's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. 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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.