Warren Buffett said: “Volatility is far from synonymous with risk”. So it can be obvious that you need to consider debt, when you think about how risky a given stock is, because too much debt can sink a business. Like many other companies Contact Energy Limited (NZSE: CEN) uses debt. But the most important question is: what risk does this debt create?
When is Debt a Problem?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. Ultimately, if the company can’t meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that he has to raise new equity at low cost, thereby constantly diluting shareholders. 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.
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How much debt does contact energy carry?
You can click on the graph below for historical figures, but it shows Contact Energy had NZ $ 835.0 million in debt in June 2021, up from NZ $ 1.18 billion a year earlier. . However, he has NZ $ 150.0 million in cash to offset this, leading to net debt of around NZ $ 685.0 million.
How healthy is Contact Energy’s balance sheet?
According to the latest published balance sheet, Contact Energy had a liability of NZ $ 622.0 million due within 12 months and a liability of NZ $ 1.48 billion due beyond 12 months. In return, he had NZ $ 150.0 million in cash and NZ $ 251.0 million in receivables due within 12 months. It therefore has liabilities totaling NZ $ 1.70 billion more than its cash and short-term receivables combined.
While that might sound like a lot, it’s not so bad since Contact Energy has a market capitalization of NZ $ 6.15 billion, and could therefore likely strengthen its balance sheet by raising capital if needed. However, it is always worth taking a close look at your ability to repay your debt.
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 earnings before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). Thus, we consider debt versus earnings with and without amortization expenses.
While Contact Energy’s low debt-to-EBITDA ratio of 1.3 suggests modest use of debt, the fact that EBIT only covered interest expense 6.8 times last year gives us pause. We therefore recommend that you keep a close eye on the impact of financing costs on the business. On top of that, Contact Energy has increased its EBIT by 32% over the past twelve months, and this growth will make it easier to process its debt. When analyzing debt levels, the balance sheet is the obvious place to start. But ultimately, the company’s future profitability will decide whether Contact Energy can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free Analyst Profit Forecast report interesting.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Over the past three years, Contact Energy has actually generated more free cash flow than EBIT. There is nothing better than cash flow to stay in the good graces of your lenders.
Our point of view
Contact Energy’s conversion of EBIT to free cash flow suggests that it can manage its debt as easily as Cristiano Ronaldo could score a goal against an Under-14 goalkeeper. And the good news doesn’t end there, as its EBIT growth rate also supports this impression! It’s also worth noting that Contact Energy belongs to the electric utility industry, which is often seen as quite defensive. Looking at the big picture, we think Contact Energy’s use of debt looks very reasonable and we don’t care. After all, reasonable leverage can increase returns on equity. When analyzing debt levels, the balance sheet is the obvious place to start. But at the end of the day, every business can contain risks that exist off the balance sheet. Note that Contact Energy displays 3 warning signs in our investment analysis , and 1 of them is a bit disturbing …
At the end of the day, it’s often best to focus on businesses that don’t have net debt. You can access our special list of these companies (all with a history of profit 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 using only 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 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 any of the stocks mentioned.