Here's Why Pinnacle West Capital (NYSE:PNW) Is Weighed Down By Its Debt Load

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 Pinnacle West Capital Corporation (NYSE:PNW) does use debt in its business. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Pinnacle West Capital

What Is Pinnacle West Capital's Net Debt?

As you can see below, at the end of September 2023, Pinnacle West Capital had US$8.84b of debt, up from US$7.84b a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.

How Healthy Is Pinnacle West Capital's Balance Sheet?

According to the last reported balance sheet, Pinnacle West Capital had liabilities of US$1.97b due within 12 months, and liabilities of US$16.0b due beyond 12 months. On the other hand, it had cash of US$15.1m and US$871.3m worth of receivables due within a year. So it has liabilities totalling US$17.1b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the US$7.73b 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, Pinnacle West Capital would probably need a major re-capitalization if its creditors were to demand repayment.

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.

Pinnacle West Capital has a rather high debt to EBITDA ratio of 5.2 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 2.5 times, suggesting it can responsibly service its obligations. Notably, Pinnacle West Capital's EBIT was pretty flat over the last year, which isn't ideal given the debt load. 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 Pinnacle West Capital'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Pinnacle West Capital burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Pinnacle West Capital's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. It's also worth noting that Pinnacle West Capital is in the Electric Utilities industry, which is often considered to be quite defensive. Taking into account all the aforementioned factors, it looks like Pinnacle West Capital has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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 Pinnacle West Capital is showing 2 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...

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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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.