U.S. Markets closed

We Think Ørsted (CPH:ORSTED) Can Stay On Top Of Its Debt

Simply Wall St

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Ørsted A/S (CPH:ORSTED) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Ørsted

How Much Debt Does Ørsted Carry?

The chart below, which you can click on for greater detail, shows that Ørsted had ø32.6b in debt in June 2019; about the same as the year before. On the flip side, it has ø32.5b in cash leading to net debt of about ø182.0m.

CPSE:ORSTED Historical Debt, August 16th 2019

How Healthy Is Ørsted's Balance Sheet?

According to the last reported balance sheet, Ørsted had liabilities of ø37.5b due within 12 months, and liabilities of ø62.1b due beyond 12 months. On the other hand, it had cash of ø32.5b and ø17.2b worth of receivables due within a year. So it has liabilities totalling ø49.8b more than its cash and near-term receivables, combined.

Given Ørsted has a humongous market capitalization of ø278.5b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Carrying virtually no net debt, Ørsted has a very light debt load indeed.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Ørsted's debt of just 0.011 times EBITDA is really very modest. And EBIT easily covered the interest expense 8.0 times over, lending force to that view. In addition to that, we're happy to report that Ørsted has boosted its EBIT by 69%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Ørsted's ability to maintain a healthy balance sheet going forward. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Ørsted burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Ørsted's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better In particular, we are dazzled with its EBIT growth rate. It's also worth noting that Ørsted is in the Electric Utilities industry, which is often considered to be quite defensive. When we consider all the elements mentioned above, it seems to us that Ørsted is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Over time, share prices tend to follow earnings per share, so if you're interested in Ørsted, you may well want to click here to check an interactive graph of its earnings per share history.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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.