These 4 Measures Indicate That CenterPoint Energy (NYSE:CNP) Is Using Debt In A Risky Way

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, CenterPoint Energy, Inc. (NYSE:CNP) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. 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 CenterPoint Energy

What Is CenterPoint Energy's Debt?

The image below, which you can click on for greater detail, shows that at September 2021 CenterPoint Energy had debt of US$16.5b, up from US$13.3b in one year. However, because it has a cash reserve of US$1.45b, its net debt is less, at about US$15.1b.

A Look At CenterPoint Energy's Liabilities

According to the last reported balance sheet, CenterPoint Energy had liabilities of US$4.51b due within 12 months, and liabilities of US$23.8b due beyond 12 months. On the other hand, it had cash of US$1.45b and US$957.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$25.9b.

The deficiency here weighs heavily on the US$16.3b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, CenterPoint Energy would probably need a major re-capitalization if its creditors were to demand repayment.

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). 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).

With a net debt to EBITDA ratio of 6.1, it's fair to say CenterPoint Energy does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 2.8 times, suggesting it can responsibly service its obligations. Even more troubling is the fact that CenterPoint Energy actually let its EBIT decrease by 4.4% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if CenterPoint Energy 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, CenterPoint Energy burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, CenterPoint Energy's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. And even its interest cover fails to inspire much confidence. We should also note that Integrated Utilities industry companies like CenterPoint Energy commonly do use debt without problems. After considering the datapoints discussed, we think CenterPoint Energy has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. Be aware that CenterPoint Energy is showing 4 warning signs in our investment analysis , and 1 of those is significant...

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.