These 4 measures indicate that Endesa (BME:ELE) is using debt extensively
Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. 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. Like many other companies Endesa, S.A. (BME:ELE) uses debt. But the more important question is: what risk does this debt create?
Why is debt risky?
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. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. 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, many companies use debt to finance their growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
See our latest analysis for Endesa
What is Endesa’s net debt?
As you can see below, at the end of December 2021, Endesa had 9.45 billion euros in debt, compared to 6.51 billion euros a year ago. Click on the image for more details. However, he also had €1.59 billion in cash, so his net debt is €7.86 billion.
How healthy is Endesa’s balance sheet?
According to the last published balance sheet, Endesa had liabilities of 15.8 billion euros due within 12 months and liabilities of 18.6 billion euros due beyond 12 months. In return, it had 1.59 billion euros in cash and 6.32 billion euros in receivables due within 12 months. Thus, its liabilities total 26.5 billion euros more than the combination of its cash and short-term receivables.
When you consider that this shortfall exceeds the company’s massive $18.9 billion market capitalization, you might well be inclined to take a close look at 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.
In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its interest coverage). Thus, we consider debt to earnings with and without amortization and depreciation expense.
Endesa’s net debt to EBITDA ratio of around 2.1 suggests only moderate use of debt. And its towering EBIT of 158 times its interest expense means that the debt burden is as light as a peacock feather. Unfortunately, Endesa’s EBIT has fallen by 16% over the past four quarters. If that kind of decline isn’t stopped, then managing his debt will be harder than selling broccoli-flavored ice cream for a bounty. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future earnings, more than anything, that will determine Endesa’s ability to maintain a healthy balance sheet in the future. 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. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, Endesa has recorded a free cash flow of 44% of its EBIT, which is lower than expected. It’s not great when it comes to paying off debt.
Our point of view
At first glance, Endesa’s EBIT growth rate left us hesitant about the stock, and its level of total liabilities was no more appealing than the single empty restaurant on the busiest night of the year. But at least it’s decent enough to cover its interest costs with its EBIT; it’s encouraging. It should also be noted that companies in the electric utility sector like Endesa generally use debt without problems. Looking at the bigger picture, it seems clear to us that Endesa’s use of debt creates risks for the business. 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. We have identified 3 warning signs with Endesa, and understanding them should be part of your investment process.
If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-neutral growth stocks right away.
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