Pinnacle West Capital (NYSE:PNW) Seems To Be Using A Lot Of Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 Pinnacle West Capital Corporation (NYSE:PNW) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Pinnacle West Capital

What Is Pinnacle West Capital's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2022 Pinnacle West Capital had US$8.13b of debt, an increase on US$7.36b, over one year. And it doesn't have much cash, so its net debt is about the same.

How Healthy Is Pinnacle West Capital's Balance Sheet?

According to the last reported balance sheet, Pinnacle West Capital had liabilities of US$1.76b due within 12 months, and liabilities of US$14.8b due beyond 12 months. On the other hand, it had cash of US$4.83m and US$608.3m worth of receivables due within a year. So its liabilities total US$16.0b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the US$8.52b 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). 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).

Pinnacle West Capital's debt is 4.9 times its EBITDA, and its EBIT cover its interest expense 3.0 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Even more troubling is the fact that Pinnacle West Capital actually let its EBIT decrease by 9.5% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. Over the last three years, Pinnacle West Capital saw substantial negative free cash flow, in total. 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. And even its interest cover fails to inspire much confidence. We should also note that Electric Utilities industry companies like Pinnacle West Capital commonly do use debt without problems. Taking into account all the aforementioned factors, it looks like Pinnacle West Capital has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 4 warning signs we've spotted with Pinnacle West Capital (including 1 which is a bit concerning) .

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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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.