We think Endesa (BME:ELE) is taking risks with its debt

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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.” So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. Above all, Endesa, S.A. (BME:ELE) is in debt. But does this debt worry shareholders?

When is debt dangerous?

Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. If things go really bad, lenders can take over the business. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.

See our latest analysis for Endesa

What is Endesa’s debt?

The image below, which you can click on for more details, shows that in March 2022, Endesa had a debt of 13.5 billion euros, compared to 7.98 billion euros in one year. However, he also had 565.0 million euros in cash, and his net debt is therefore 12.9 billion euros.

BME: ELE Debt to Equity June 19, 2022

A look at Endesa’s responsibilities

Zooming in on the latest balance sheet data, we can see that Endesa had liabilities of €21.6 billion due within 12 months and liabilities of €21.4 billion due beyond. On the other hand, it had cash of €565.0 million and €6.66 billion in receivables at less than one year. It therefore has liabilities totaling 35.8 billion euros more than its cash and short-term receivables, combined.

This deficit casts a shadow over the 20.2 billion euro company, like a colossus towering above mere mortals. We would therefore be watching his balance sheet closely, no doubt. Ultimately, Endesa would likely need a major recapitalization if its creditors were to demand repayment.

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.

Endesa’s net debt is 3.6 times its EBITDA, representing significant but still reasonable leverage. But its EBIT was around 27.4 times its interest expense, implying that the company isn’t really paying a high cost to maintain that level of leverage. Even if the low cost turns out to be unsustainable, that’s a good sign. Unfortunately, Endesa has seen its EBIT drop by 4.1% over the last twelve months. If this earnings trend continues, its leverage will become heavy like the heart of a polar bear looking at its only cub. 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 Endesa can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

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, Endesa has recorded a free cash flow of 32% of its EBIT, which is lower than expected. It’s not great when it comes to paying off debt.

Our point of view

We would go so far as to say that Endesa’s level of total liabilities was disappointing. But on the bright side, its interest coverage is a good sign and makes us more optimistic. It should also be noted that Endesa is part of the electric utility sector, which is often considered quite defensive. Overall, we think it’s fair to say that Endesa has enough debt that there are real risks around the balance sheet. If all goes well, it can pay off, but the downside of 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 outside of the balance sheet. For example, we have identified 3 warning signs for Endesa (2 are a little nasty) you should be aware of.

In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.

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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