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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies The Southern Company (NYSE:SO) makes use of debt. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for Southern
What Is Southern's Debt?
As you can see below, at the end of September 2024, Southern had US$63.6b of debt, up from US$60.8b 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 Southern's Liabilities
Zooming in on the latest balance sheet data, we can see that Southern had liabilities of US$12.2b due within 12 months and liabilities of US$94.9b due beyond that. Offsetting these obligations, it had cash of US$1.02b as well as receivables valued at US$4.42b due within 12 months. So it has liabilities totalling US$101.6b more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's massive market capitalization of US$92.4b, we think shareholders really should watch Southern's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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).
Southern's debt is 4.8 times its EBITDA, and its EBIT cover its interest expense 2.9 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Looking on the bright side, Southern boosted its EBIT by a silky 40% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Southern can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Southern actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Our View
Mulling over Southern's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We should also note that Electric Utilities industry companies like Southern commonly do use debt without problems. Overall, we think it's fair to say that Southern has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. For example Southern has 3 warning signs (and 1 which can't be ignored) we think you should know about.
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.
About NYSE:SO
Southern
Through its subsidiaries, engages in the generation, transmission, and distribution of electricity.
Solid track record average dividend payer.