These 4 metrics indicate that Energy Development (NSE: ENERGYDEV) is making extensive use of debt
Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. We can see that Energy Development Company Limited (NSE: ENERGYDEV) uses debt in its business. But does this debt worry shareholders?
When is debt dangerous?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. When we think about a company’s use of debt, we first look at cash and debt together.
Discover our latest analysis for energy development
What is Energy Development’s debt?
The graph below, which you can click on for more details, shows that Energy Development had ₹1.61 billion in debt as of September 2021; about the same as the previous year. However, he also had ₹99.3 million in cash, and hence his net debt is ₹1.51 billion.
How strong is Energy Development’s balance sheet?
Zooming in on the latest balance sheet data, we can see that Energy Development had liabilities of ₹1.04 billion due within 12 months and liabilities of ₹1.58 billion due beyond. On the other hand, it had cash of ₹99.3 million and ₹548.9 million of receivables due within one year. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables by ₹1.97 billion.
When you consider that this shortfall exceeds the company’s ₹1.47 billion market capitalization, you might well be inclined to take a close look at the balance sheet. In theory, extremely large dilution would be required if the company were forced to repay its debts by raising capital at the current share price.
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). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Energy Development shareholders face the double whammy of a high net debt to EBITDA ratio (5.6) and fairly low interest coverage, as EBIT is only 0.91 times interest charge. This means that we would consider him to be heavily indebted. The silver lining is that Energy Development grew its EBIT by 211% last year, which feeds like youthful idealism. If he can keep walking on this path, he will be able to get rid of his debt with relative ease. The balance sheet is clearly the area to focus on when analyzing debt. But you can’t look at debt in total isolation; since Energy Development will need revenue to repay this debt. So, if you want to know more about its earnings, it may be worth checking out this graph of its long-term trend.
Finally, a company can only repay its debts with cold hard cash, not with book profits. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Fortunately for all shareholders, Energy Development has actually produced more free cash flow than EBIT over the past three years. There’s nothing better than incoming money to stay in the good books of your lenders.
Our point of view
While the coverage of Energy Development interests makes us nervous. The EBIT to free cash flow conversion and the EBIT growth rate were encouraging signs. It should also be noted that companies in the electric utility sector like Energy Development generally use debt without a problem. From all the angles mentioned above, it seems to us that Energy Development is a bit risky investment because of its debt. Not all risk is bad, as it can increase stock price returns if it pays off, but this leverage risk is worth keeping in mind. 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. Know that Energy Development shows 3 warning signs in our investment analysis and 1 of them is significant…
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.