FirstEnergy (NYSE:FE) Seems To Be Using A Lot Of Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 FirstEnergy Corp. (NYSE:FE) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

Check out our latest analysis for FirstEnergy

What Is FirstEnergy's Net Debt?

As you can see below, at the end of June 2023, FirstEnergy had US$24.0b of debt, up from US$21.1b a year ago. Click the image for more detail. And it doesn't have much cash, so its net debt is about the same.

How Strong Is FirstEnergy's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that FirstEnergy had liabilities of US$4.15b due within 12 months and liabilities of US$31.9b due beyond that. Offsetting these obligations, it had cash of US$171.0m as well as receivables valued at US$1.46b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$34.5b.

The deficiency here weighs heavily on the US$20.3b 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 definitely think shareholders need to watch this one closely. At the end of the day, FirstEnergy 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).

Weak interest cover of 1.9 times and a disturbingly high net debt to EBITDA ratio of 6.8 hit our confidence in FirstEnergy like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Investors should also be troubled by the fact that FirstEnergy saw its EBIT drop by 14% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. 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 FirstEnergy'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 always check how much of that EBIT is translated into free cash flow. Over the last three years, FirstEnergy recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

To be frank both FirstEnergy's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And furthermore, its conversion of EBIT to free cash flow also fails to instill confidence. We should also note that Electric Utilities industry companies like FirstEnergy commonly do use debt without problems. We think the chances that FirstEnergy has too much debt a very significant. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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 FirstEnergy is showing 3 warning signs in our investment analysis , and 2 of those are a bit unpleasant...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.