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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. 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 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. 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. 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. When we think about a company’s use of debt, we first look at 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. On the flip side, it has US$880.0m in cash leading to net debt of about US$36.2b.
How Healthy Is Exelon’s Balance Sheet?
The latest balance sheet data shows that Exelon had liabilities of US$12.2b due within a year, and liabilities of US$75.7b falling due after 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 outweigh the sum of its cash and (near-term) receivables by US$81.4b.
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 After all, Exelon would likely require a major re-capitalisation if it had to pay its creditors today. Because it carries more debt than cash, we think it’s worth watching Exelon’s balance sheet over time.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Exelon’s debt is only 3.80 times its EBITDA, and its EBIT cover its interest expense 2.97 times over. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. 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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Exelon 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.
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, 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. Having said that, its ability to grow its EBIT isn’t such a worry. It’s also worth noting that Exelon is in the Electric Utilities industry, which is often considered to be quite defensive. After considering the datapoints discussed, we think 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!
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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