Is Pinnacle West Capital (NYSE:PNW) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Pinnacle West Capital Corporation (NYSE:PNW) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Pinnacle West Capital

What Is Pinnacle West Capital's Debt?

As you can see below, at the end of June 2023, Pinnacle West Capital had US$8.79b of debt, up from US$7.78b a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.

A Look At Pinnacle West Capital's Liabilities

We can see from the most recent balance sheet that Pinnacle West Capital had liabilities of US$1.93b falling due within a year, and liabilities of US$16.0b due beyond that. Offsetting these obligations, it had cash of US$7.66m as well as receivables valued at US$675.7m due within 12 months. So it has liabilities totalling US$17.2b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the US$8.77b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Pinnacle West Capital shareholders face the double whammy of a high net debt to EBITDA ratio (5.5), and fairly weak interest coverage, since EBIT is just 2.4 times the interest expense. This means we'd consider it to have a heavy debt load. Investors should also be troubled by the fact that Pinnacle West Capital saw its EBIT drop by 12% 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. 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 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Pinnacle West Capital burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Pinnacle West Capital's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its interest cover also fails to instill confidence. It's also worth noting that Pinnacle West Capital is in the Electric Utilities industry, which is often considered to be quite defensive. Considering all the factors previously mentioned, we think that Pinnacle West Capital really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. 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. To that end, you should learn about the 3 warning signs we've spotted with Pinnacle West Capital (including 2 which are concerning) .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.