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. As with many other companies Terna - Rete Elettrica Nazionale Società per Azioni (BIT:TRN) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Terna - Rete Elettrica Nazionale Società per Azioni's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Terna - Rete Elettrica Nazionale Società per Azioni had debt of €10.0b, up from €8.96b in one year. However, it does have €1.71b in cash offsetting this, leading to net debt of about €8.32b.
How Healthy Is Terna - Rete Elettrica Nazionale Società per Azioni's Balance Sheet?
According to the last reported balance sheet, Terna - Rete Elettrica Nazionale Società per Azioni had liabilities of €3.82b due within 12 months, and liabilities of €9.93b due beyond 12 months. Offsetting this, it had €1.71b in cash and €1.64b in receivables that were due within 12 months. So it has liabilities totalling €10.4b more than its cash and near-term receivables, combined.
This is a mountain of leverage even relative to its gargantuan market capitalization of €11.5b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Terna - Rete Elettrica Nazionale Società per Azioni's net debt is 5.0 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 14.3 is very high, suggesting that the interest expense may well rise in the future, even if there hasn't yet been a major cost attached to that debt. Notably Terna - Rete Elettrica Nazionale Società per Azioni's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Terna - Rete Elettrica Nazionale Società per Azioni'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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Terna - Rete Elettrica Nazionale Società per Azioni recorded free cash flow of 42% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Neither Terna - Rete Elettrica Nazionale Società per Azioni's ability handle its debt, based on its EBITDA, nor its level of total liabilities gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. We should also note that Electric Utilities industry companies like Terna - Rete Elettrica Nazionale Società per Azioni commonly do use debt without problems. When we consider all the factors discussed, it seems to us that Terna - Rete Elettrica Nazionale Società per Azioni is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. Given Terna - Rete Elettrica Nazionale Società per Azioni 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.
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 email@example.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.