Howard Marks put it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about … and every investor practice that I know is worried. So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the risk level of a business. We can see that Neoenergia SA (BVMF: NEOE3) uses debt in its business. But the real question is whether this debt makes the business risky.
What risk does debt entail?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. Of course, debt can be an important tool in businesses, especially capital intensive businesses. When we look at debt levels, we first look at cash and debt levels, together.
See our latest analysis for Neoenergia
What is Neoenergia’s debt?
As you can see below, at the end of September 2021, Neoenergia had a debt of R $ 34.4 billion, up from R $ 26.7 billion a year ago. Click on the image for more details. However, he has 4.41 billion reais in cash offsetting this, which leads to a net debt of around 30.0 billion reais.
How strong is Neoenergia’s balance sheet?
Zooming in on the latest balance sheet data, we can see that Neoenergia had liabilities of R $ 19.7 billion due within 12 months and R $ 37.1 billion in liabilities beyond. On the other hand, he had cash of 4.41 billion reais and 11.1 billion reais in debts due within one year. Thus, its liabilities exceed the sum of its cash and (short-term) receivables by R $ 41.3 billion.
This deficit casts a shadow over the R $ 20.3 billion society like a towering colossus of mere mortals. We therefore believe that shareholders should watch it closely. After all, Neoenergia would likely need a major recapitalization if it were to pay its creditors today.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
Neoenergia’s debt is 3.1 times its EBITDA and its EBIT covers 6.7 times its interest charges. This suggests that while debt levels are significant, we would stop calling them problematic. Importantly, Neoenergia has increased its EBIT by 69% over the past twelve months, and this growth will make it easier to process its debt. The balance sheet is clearly the area to focus on when analyzing debt. But it is future profits, more than anything, that will determine Neoenergia’s ability to maintain a healthy balance sheet in the future. So, if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a business can only repay its debts with hard cash, not with book profits. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. Over the past three years, Neoenergia has recorded a significant negative free cash flow overall. While this may be the result of spending for growth, it makes debt much riskier.
Our point of view
At first glance, Neoenergia’s conversion of EBIT to free cash flow left us hesitant about the stock, and its total liability level was no more appealing than the single empty restaurant on the busiest night of the year. year. But on the positive side, its EBIT growth rate is a good sign and makes us more optimistic. It’s also worth noting that Neoenergia is in the electric utility industry, which is often seen as quite defensive. Overall, we think it’s fair to say that Neoenergia has enough debt that there is real risk around the balance sheet. If all goes well it may pay off, but the downside to this debt is a greater risk of permanent losses. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. These risks can be difficult to spot. Every business has them, and we’ve spotted 3 warning signs for Neoenergia (including 2 significant!) that you should know.
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.
Do you have any feedback on this item? Are you worried about the content? Get in touch with us directly. You can also send an email to the editorial team (at) simplywallst.com.