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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that PNM Resources, Inc. (NYSE:PNM) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does PNM Resources Carry?
The image below, which you can click on for greater detail, shows that at March 2019 PNM Resources had debt of US$3.17b, up from US$2.82b in one year. However, because it has a cash reserve of US$180.1m, its net debt is less, at about US$2.99b.
A Look At PNM Resources's Liabilities
According to the last reported balance sheet, PNM Resources had liabilities of US$664.1m due within 12 months, and liabilities of US$4.83b due beyond 12 months. Offsetting this, it had US$180.1m in cash and US$155.1m in receivables that were due within 12 months. So its liabilities total US$5.16b more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's US$4.02b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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).
Weak interest cover of 2.0 times and a disturbingly high net debt to EBITDA ratio of 5.9 hit our confidence in PNM Resources like a one-two punch to the gut. The debt burden here is substantial. Even worse, PNM Resources saw its EBIT tank 26% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if PNM Resources can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, PNM Resources actually recorded a cash outflow, overall. 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.
To be frank both PNM Resources's net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. It's also worth noting that PNM Resources is in the Electric Utilities industry, which is often considered to be quite defensive. After considering the datapoints discussed, we think PNM Resources has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Given our concerns about PNM Resources's debt levels, it seems only prudent to check if insiders have been ditching the stock.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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