Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Public Joint stock company Rosseti Lenenergo (MCX:LSNG) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Rosseti Lenenergo's Net Debt?
As you can see below, Rosseti Lenenergo had ₽25.6b of debt at September 2020, down from ₽30.9b a year prior. However, because it has a cash reserve of ₽6.86b, its net debt is less, at about ₽18.7b.
A Look At Rosseti Lenenergo's Liabilities
According to the last reported balance sheet, Rosseti Lenenergo had liabilities of ₽36.4b due within 12 months, and liabilities of ₽33.7b due beyond 12 months. On the other hand, it had cash of ₽6.86b and ₽3.25b worth of receivables due within a year. So it has liabilities totalling ₽60.0b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of ₽64.4b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Rosseti Lenenergo has a low net debt to EBITDA ratio of only 0.53. And its EBIT easily covers its interest expense, being 14.9 times the size. So we're pretty relaxed about its super-conservative use of debt. And we also note warmly that Rosseti Lenenergo grew its EBIT by 13% last year, making its debt load easier to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Rosseti Lenenergo's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Rosseti Lenenergo reported free cash flow worth 10.0% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
When it comes to the balance sheet, the standout positive for Rosseti Lenenergo was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. We would also note that Electric Utilities industry companies like Rosseti Lenenergo commonly do use debt without problems. When we consider all the factors mentioned above, we do feel a bit cautious about Rosseti Lenenergo's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There's no doubt that we learn most about debt from the balance sheet. 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 Rosseti Lenenergo you should know about.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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