Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Galp Energia, SGPS, S.A. (ELI:GALP) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Galp Energia SGPS's Net Debt?
The image below, which you can click on for greater detail, shows that Galp Energia SGPS had debt of €3.01b at the end of June 2019, a reduction from €3.39b over a year. On the flip side, it has €1.41b in cash leading to net debt of about €1.60b.
How Strong Is Galp Energia SGPS's Balance Sheet?
The latest balance sheet data shows that Galp Energia SGPS had liabilities of €3.31b due within a year, and liabilities of €4.87b falling due after that. On the other hand, it had cash of €1.41b and €1.84b worth of receivables due within a year. So its liabilities total €4.93b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Galp Energia SGPS is worth a massive €11.3b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Galp Energia SGPS's net debt is only 0.73 times its EBITDA. And its EBIT covers its interest expense a whopping 38.4 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that Galp Energia SGPS saw its EBIT decline by 4.4% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Galp Energia SGPS's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Galp Energia SGPS recorded free cash flow of 41% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
On our analysis Galp Energia SGPS's interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to grow its EBIT. When we consider all the factors mentioned above, we do feel a bit cautious about Galp Energia SGPS's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Given Galp Energia SGPS has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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