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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.’ 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, Public Service Enterprise Group Incorporated (NYSE:PEG) does carry debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Public Service Enterprise Group’s Debt?
As you can see below, at the end of March 2019, Public Service Enterprise Group had US$15.3b of debt, up from US$13.7b 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 Public Service Enterprise Group’s Balance Sheet?
We can see from the most recent balance sheet that Public Service Enterprise Group had liabilities of US$4.47b falling due within a year, and liabilities of US$26.5b due beyond that. Offsetting this, it had US$66.0m in cash and US$1.79b in receivables that were due within 12 months. So it has liabilities totalling US$29.1b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its very significant market capitalization of US$30.6b, so it does suggest shareholders should keep an eye on Public Service Enterprise Group’s use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry. Either way, since Public Service Enterprise Group 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).
Public Service Enterprise Group’s debt is only 4.09 times its EBITDA, and its EBIT cover its interest expense 5.40 times over. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Unfortunately, Public Service Enterprise Group saw its EBIT slide 7.1% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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 Public Service Enterprise Group’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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Public Service Enterprise Group burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Mulling over Public Service Enterprise Group’s attempt at converting EBIT to free cash flow, we’re certainly not enthusiastic. Having said that, its ability to cover its interest expense with its EBIT isn’t such a worry. We should also note that Integrated Utilities industry companies like Public Service Enterprise Group commonly do use debt without problems. We’re quite clear that we consider Public Service Enterprise Group to be really rather risky, as a result of its debt. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on the balance sheet . Given our hesitation about the stock, it would be good to know if Public Service Enterprise Group insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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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.