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. We can see that Emera Incorporated (TSE: EMA) uses debt in its activities. But should shareholders worry about its use of debt?
When is debt a problem?
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. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. When we think about a company’s use of debt, we first look at cash and debt together.
See our latest analysis for Emera
What is Emera’s net debt?
As you can see below, at the end of March 2022, Emera had C$16.2 billion in debt, up from C$15.5 billion a year ago. Click on the image for more details. On the other hand, it has C$381.0 million in cash, resulting in a net debt of approximately C$15.8 billion.
A look at Emera’s responsibilities
We can see from the most recent balance sheet that Emera had liabilities of C$5.12 billion maturing in one year, and liabilities of C$18.9 billion due beyond. On the other hand, it had liquid assets of C$381.0 million and C$1.09 billion of receivables due within one year. Thus, its liabilities total C$22.6 billion more than the combination of its cash and short-term receivables.
Given that this deficit is actually higher than the company’s massive market capitalization of C$16.4 billion, we think shareholders really should be watching Emera’s debt levels, like a parent watching her child riding a bike for the first time. 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 measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). Thus, we consider debt to earnings with and without amortization and depreciation expense.
Emera shareholders face the double whammy of a high net debt to EBITDA ratio (7.9) and quite low interest coverage, as EBIT is only 1.8 times expenses of interests. The debt burden here is considerable. Even more troubling is the fact that Emera has actually let its EBIT decline by 9.5% over the past year. If this earnings trend continues, the company will face an uphill battle to pay off its debt. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future earnings, more than anything, that will determine Emera’s ability to maintain a healthy balance sheet in the future. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, while the taxman may love accounting profits, lenders only accept cash. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, Emera has experienced significant negative free cash flow, in total. While this may be the result of spending for growth, it makes debt much riskier.
Our point of view
To be frank, Emera’s net debt to EBITDA ratio and history of converting EBIT to free cash flow makes us rather uncomfortable with its debt levels. Moreover, his level of total liabilities also fails to inspire confidence. It should also be noted that companies in the electric utility sector like Emera generally use debt without a problem. Considering all the above factors, it seems that Emera has too much debt. That kind of risk is acceptable to some, but it certainly doesn’t float our boat. 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. Know that Emera displays 3 warning signs in our investment analysis and 2 of them make us uncomfortable…
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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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.