Does Rosseti (MCX:RSTI) Have A Healthy Balance Sheet?

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. We can see that Rosseti, Public Joint Stock Company (MCX:RSTI) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. 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 Rosseti

How Much Debt Does Rosseti Carry?

The chart below, which you can click on for greater detail, shows that Rosseti had ₽525.2b in debt in September 2020; about the same as the year before. However, it also had ₽144.6b in cash, and so its net debt is ₽380.6b.

How Healthy Is Rosseti's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Rosseti had liabilities of ₽372.7b due within 12 months and liabilities of ₽714.3b due beyond that. On the other hand, it had cash of ₽144.6b and ₽136.6b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₽805.8b.

This deficit casts a shadow over the ₽333.6b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Rosseti would probably need a major re-capitalization if its creditors were to demand repayment.

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.

With net debt sitting at just 1.4 times EBITDA, Rosseti is arguably pretty conservatively geared. And it boasts interest cover of 9.5 times, which is more than adequate. On the other hand, Rosseti's EBIT dived 17%, 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 it is future earnings, more than anything, that will determine Rosseti'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Rosseti created free cash flow amounting to 11% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

To be frank both Rosseti's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. It's also worth noting that Rosseti is in the Electric Utilities industry, which is often considered to be quite defensive. We're quite clear that we consider Rosseti to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Rosseti is showing 2 warning signs in our investment analysis , you should know about...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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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