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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.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies. Exelon Corporation (NYSE:EXC) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Exelon’s Net Debt?
As you can see below, Exelon had US$37.1b of debt, at March 2019, which is about the same the year before. You can click the chart for greater detail. However, it does have US$880.0m in cash offsetting this, leading to net debt of about US$36.2b.
How Healthy Is Exelon’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Exelon had liabilities of US$12.2b due within 12 months and liabilities of US$75.7b due beyond that. Offsetting this, it had US$880.0m in cash and US$5.63b in receivables that were due within 12 months. So its liabilities total US$81.4b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the US$46.5b 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, Exelon would probably need a major re-capitalization if its creditors were to demand repayment. Either way, since Exelon does have more debt than cash, it’s worth keeping an eye on its balance sheet.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
Exelon has a debt to EBITDA ratio of 3.80 and its EBIT covered its interest expense 2.97 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Even more troubling is the fact that Exelon actually let its EBIT decrease by 3.3% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. 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 Exelon’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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Exelon created free cash flow amounting to 4.0% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks some a little paranoia about is ability to extinguish debt.
Mulling over Exelon’s attempt at staying on top of its total liabilities, we’re certainly not enthusiastic. But at least its EBIT growth rate is not so bad. It’s also worth noting that Exelon is in the Electric Utilities industry, which is often considered to be quite defensive. Taking into account all the aforementioned factors, it looks like Exelon has too much debt. That sort of riskiness is ok for some, but it certainly doesn’t float our boat. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Exelon’s dividend history, without delay!
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.