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 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 NRG Energy, Inc. (NYSE:NRG) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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.
What Is NRG Energy's Net Debt?
The chart below, which you can click on for greater detail, shows that NRG Energy had US$5.82b in debt in June 2020; about the same as the year before. On the flip side, it has US$418.0m in cash leading to net debt of about US$5.40b.
A Look At NRG Energy's Liabilities
The latest balance sheet data shows that NRG Energy had liabilities of US$2.16b due within a year, and liabilities of US$8.43b falling due after that. Offsetting these obligations, it had cash of US$418.0m as well as receivables valued at US$1.02b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$9.15b.
Given this deficit is actually higher than the company's market capitalization of US$8.23b, we think shareholders really should watch NRG Energy's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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.
NRG Energy has a debt to EBITDA ratio of 2.6 and its EBIT covered its interest expense 3.8 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. The good news is that NRG Energy grew its EBIT a smooth 40% over the last twelve months. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. 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 NRG Energy's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, NRG Energy actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
NRG Energy's conversion of EBIT to free cash flow was a real positive on this analysis, as was its EBIT growth rate. But truth be told its level of total liabilities had us nibbling our nails. We would also note that Electric Utilities industry companies like NRG Energy commonly do use debt without problems. Considering this range of data points, we think NRG Energy is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 4 warning signs for NRG Energy you should be aware of, and 2 of them shouldn't be ignored.
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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