Howard Marks said 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 that every practical investor that I know is worried”. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We can see that Elecnor, SA (BME:ENO) uses debt in its business. But the more important question is: what risk does this debt create?
When is debt dangerous?
Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. In the worst case, 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 at a low price, thereby permanently diluting shareholders. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
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What is Elecnor’s debt?
The image below, which you can click on for more details, shows that in June 2022, Elecnor had a debt of 1.06 billion euros, compared to 978.4 million euros in one year. However, because it has a cash reserve of €425.0 million, its net debt is lower, at approximately €633.0 million.
What is the state of Elecnor’s balance sheet?
Looking at the latest balance sheet data, we can see that Elecnor had liabilities of €1.86 billion due within 12 months and liabilities of €902.6 million due beyond. In compensation for these obligations, it had cash of €425.0 million as well as receivables worth €1.36 billion at less than 12 months. It therefore has liabilities totaling 977.4 million euros more than its cash and short-term receivables, combined.
When we consider that this deficit exceeds the market capitalization of the company by €855.2 million, we may well be inclined to carefully review the balance sheet. In the scenario where the company were to quickly clean up its balance sheet, it seems likely that shareholders would suffer 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 ).
Elecnor’s net debt is at a very reasonable 2.5 times its EBITDA, while its EBIT covered its interest charges at only 4.2 times last year. While that doesn’t worry us too much, it does suggest that interest payments are a bit of a burden. If Elecnor can continue to grow EBIT at last year’s pace of 18% over last year, then it will find its debt more manageable. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Elecnor can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, Elecnor’s free cash flow amounted to 38% of its EBIT, less than expected. This low cash conversion makes debt management more difficult.
Our point of view
The level of Elecnor’s total commitments was a real negative point in this analysis, even if the other factors that we took into account presented it in a much more favorable light. In particular, its EBIT growth rate was invigorating. If we consider all the factors mentioned, it seems to us that Elecnor is taking risks with its recourse to debt. While this debt may increase returns, we believe the company now has sufficient leverage. When analyzing debt levels, the balance sheet is the obvious starting point. 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 Elecnor of which you should be aware.
If you are interested in investing in companies that can generate profits without the burden of debt, then check out this free list of growing companies that have net cash on the balance sheet.
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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.
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