We Think Second Generating Company of the Electric Power Wholesale Market (MCX:OGKB) Is Taking Some Risk With Its Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Public Joint-Stock Company "Second Generating Company of the Electric Power Wholesale Market" (MCX:OGKB) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Second Generating Company of the Electric Power Wholesale Market

How Much Debt Does Second Generating Company of the Electric Power Wholesale Market Carry?

The image below, which you can click on for greater detail, shows that Second Generating Company of the Electric Power Wholesale Market had debt of ₽35.2b at the end of June 2020, a reduction from ₽47.0b over a year. Net debt is about the same, since the it doesn't have much cash.

How Healthy Is Second Generating Company of the Electric Power Wholesale Market's Balance Sheet?

The latest balance sheet data shows that Second Generating Company of the Electric Power Wholesale Market had liabilities of ₽33.9b due within a year, and liabilities of ₽43.2b falling due after that. Offsetting these obligations, it had cash of ₽324.0m as well as receivables valued at ₽20.8b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₽56.1b.

This deficit is considerable relative to its market capitalization of ₽78.6b, so it does suggest shareholders should keep an eye on Second Generating Company of the Electric Power Wholesale Market's use of debt. 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.

With net debt sitting at just 1.1 times EBITDA, Second Generating Company of the Electric Power Wholesale Market is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 8.1 times the interest expense over the last year. The modesty of its debt load may become crucial for Second Generating Company of the Electric Power Wholesale Market if management cannot prevent a repeat of the 21% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Second Generating Company of the Electric Power Wholesale Market 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Second Generating Company of the Electric Power Wholesale Market produced sturdy free cash flow equating to 70% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Second Generating Company of the Electric Power Wholesale Market's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its conversion of EBIT to free cash flow was re-invigorating. Looking at all the angles mentioned above, it does seem to us that Second Generating Company of the Electric Power Wholesale Market is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 Second Generating Company of the Electric Power Wholesale Market 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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This article by Simply Wall St is general in nature. 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.
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