Contact Energy (NZSE:CEN) appears to be using debt sparingly

Warren Buffett said: “Volatility is far from synonymous with risk. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. Like many other companies Contact Energy Limited (NZSE:CEN) uses debt. But the more important question is: what risk does this debt create?

What risk does debt carry?

Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business 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.

Check out our latest analysis for Contact Energy

What is Contact Energy’s debt?

You can click on the chart below for historical figures, but it shows Contact Energy had NZ$905.0 million in debt in December 2021, up from NZ$1.12 billion a year earlier. . On the other hand, he has NZ$71.0 million in cash, resulting in a net debt of approximately NZ$834.0 million.

NZSE:CEN Debt to Equity May 18, 2022

How healthy is Contact Energy’s balance sheet?

The latest balance sheet data shows Contact Energy had liabilities of NZ$451.0 million due within one year, and liabilities of NZ$1.58 billion falling due thereafter. . As compensation for these obligations, it had cash of NZ$71.0 million and receivables valued at NZ$186.0 million maturing within 12 months. Thus, its liabilities total NZ$1.77 billion more than the combination of its cash and short-term receivables.

While that might sound like a lot, it’s not that bad since Contact Energy has a market capitalization of NZ$6.07 billion, so it could likely bolster its balance sheet by raising capital if needed. But we definitely want to keep our eyes peeled for indications that its debt is too risky.

In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its interest coverage). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).

With a net debt of only 1.4 times EBITDA, Contact Energy is arguably quite conservative. And this view is supported by strong interest coverage, with EBIT amounting to 9.6 times interest expense over the past year. In addition, Contact Energy has increased its EBIT by 45% over the last twelve months, and this growth will facilitate the management of its debt. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Contact Energy can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.

Finally, a company can only repay its debts with cold hard cash, not with book profits. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Contact Energy has produced strong free cash flow equivalent to 80% of its EBIT, which is what we expected. This cold hard cash allows him to reduce his debt whenever he wants.

Our point of view

The good news is that Contact Energy’s demonstrated ability to increase EBIT delights us like a fluffy puppy does a toddler. And the good news doesn’t stop there, since its conversion of EBIT into free cash flow also confirms this impression! We also note that companies in the electric utility sector like Contact Energy generally use debt without issue. Overall, we think Contact Energy’s use of debt seems entirely reasonable and we are not concerned about that. Although debt carries risks, when used wisely, it can also generate a higher return on equity. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. For example – Contact Energy a 2 warning signs we think you should know.

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

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.

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John A. Bogar