Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. Above all, Rio Paranapanema Energia SA (BVMF:GEPA3) is in debt. But the more important question is: what risk does this debt create?
Why is debt risky?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. The first thing to do when considering how much debt a business has is to look at its cash and debt together.
Discover our latest analysis for Rio Paranapanema Energia
What is Rio Paranapanema Energia’s net debt?
The image below, which you can click on for more details, shows that in December 2021, Rio Paranapanema Energia had a debt of R$1.29 billion, compared to R$1.07 billion in one year . However, since it has a cash reserve of R$185.0 million, its net debt is lower at around R$1.11 billion.
How strong is Rio Paranapanema Energia’s balance sheet?
Zooming in on the latest balance sheet data, we can see that Rio Paranapanema Energia had liabilities of R$993.4 million due within 12 months and liabilities of R$1.06 billion due beyond. In return, he had 185.0 million reais in cash and 190.0 million reais in receivables which had to be paid within 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables of 1.68 billion reais.
This deficit is considerable compared to its market capitalization of 2.47 billion reais, so it suggests that shareholders monitor the use of debt by Rio Paranapanema Energia. If its lenders asked it to shore up its balance sheet, shareholders would likely face significant dilution.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
While Rio Paranapanema Energia has a fairly reasonable net debt to EBITDA ratio of 2.5, its interest coverage looks low at 1.1. The main reason for this is that it has such high depreciation and amortization. These fees may be non-monetary, so they could be excluded when it comes to repaying the debt. But accounting fees are there for a reason: some assets seem to lose value. Either way, it’s safe to say that the company has significant debt. Shareholders should know that Rio Paranapanema Energia’s EBIT fell 88% last year. If this decline continues, it will be more difficult to repay debts than to sell foie gras at a vegan convention. There is no doubt that we learn the most about debt from the balance sheet. But you can’t look at debt in total isolation; since Rio Paranapanema Energia will need revenue to repay this debt. So, if you want to know more about its earnings, it might be worth checking out this graph of its long-term trend.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Rio Paranapanema Energia has generated free cash flow of 12% of its EBIT, an uninspiring performance. For us, such a low cash conversion creates a bit of paranoia about the ability to extinguish the debt.
Our point of view
At first glance, Rio Paranapanema Energia’s interest coverage left us hesitant about the stock, and its EBIT growth rate was no more appealing than the single empty restaurant on the busiest night of the year. But at least its net debt to EBITDA isn’t that bad. It should also be noted that companies in the electric utility sector like Rio Paranapanema Energia generally use debt without problems. Overall, it seems to us that Rio Paranapanema Energia’s balance sheet is really a risk for the company. For this reason, we are quite cautious about the stock and believe shareholders should keep a close eye on its liquidity. 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 outside of the balance sheet. For example, we have identified 1 warning sign for Rio Paranapanema Energia of which you should be aware.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.