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Is MGE Energy (NASDAQ:MGEE) Using Too Much Debt?

Simply Wall St

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that MGE Energy, Inc. (NASDAQ:MGEE) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for MGE Energy

What Is MGE Energy's Net Debt?

As you can see below, at the end of June 2019, MGE Energy had US$519.3m of debt, up from US$448.8m a year ago. Click the image for more detail. However, it also had US$69.9m in cash, and so its net debt is US$449.4m.

NasdaqGS:MGEE Historical Debt, September 11th 2019

A Look At MGE Energy's Liabilities

Zooming in on the latest balance sheet data, we can see that MGE Energy had liabilities of US$128.2m due within 12 months and liabilities of US$1.07b due beyond that. Offsetting this, it had US$69.9m in cash and US$64.9m in receivables that were due within 12 months. So its liabilities total US$1.06b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since MGE Energy has a market capitalization of US$2.55b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

MGE Energy's net debt is sitting at a very reasonable 2.5 times its EBITDA, while its EBIT covered its interest expense just 5.6 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Sadly, MGE Energy's EBIT actually dropped 6.3% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since MGE Energy will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Over the last three years, MGE Energy recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.

Our View

We'd go so far as to say MGE Energy's conversion of EBIT to free cash flow was disappointing. But at least its interest cover is not so bad. It's also worth noting that MGE Energy is in the Electric Utilities industry, which is often considered to be quite defensive. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making MGE Energy stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. Over time, share prices tend to follow earnings per share, so if you're interested in MGE Energy, you may well want to click here to check an interactive graph of its earnings per share history.

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.