David Iben put it well when he said, “Volatility is not a risk we care about. What we care about is preventing permanent loss of capital.’ It seems the smart money knows that debt – which usually comes with bankruptcies – is a very important factor when you assess how risky a company is. important, Hydro One Limited (TSE:H) does bear debt. But should shareholders be concerned about using debt?
When is debt dangerous?
Debt helps a company until the company struggles to pay it off, either with new capital or free cash flow. If the company can’t meet its legal obligations to repay debts, shareholders may end up walking away with nothing. However, a more common (but still expensive) situation is that a company has to dilute shareholders at a cheap share price to get its debt under control. That said, the most common situation is for a company to manage its debt fairly well — and for its own benefit. When we examine debt levels, we first look at both cash and debt levels together.
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What is Hydro One’s fault?
The chart below, which you can click on for more details, shows that Hydro One had CA$13.9 billion in debt in March 2021; about the same as the year before. And it doesn’t have a lot of cash, so its net debt is about the same.
A Look at Hydro One’s Commitments
If we zoom in on the most recent balance sheet data, we can see that Hydro One had CA$2.98 billion in debt due within 12 months and CA$16.3 billion in liabilities due after that. On the other hand, it had a cash value of CA$121.0 million and a value of CA$1.02 billion in receivables due within a year. So his liabilities outweigh CA$18.2 billion against the sum of his cash and receivables.
This is tremendous leverage, even relative to its gargantuan market cap of CA$18.3 billion. This suggests that shareholders would be highly diluted if the company had to strengthen its balance sheet quickly.
We use two main ratios to inform us of debt levels relative to income. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how often earnings before interest and taxes (EBIT) will cover interest costs (or interest coverage for short). So we consider debt in relation to earnings, both with and without depreciation and amortization costs.
Hydro One has a fairly high debt-to-EBITDA ratio of 5.9, indicating significant debt. But the good news is that it has a fairly reassuring 3.4 times interest coverage, suggesting it can meet its obligations responsibly. One redeeming factor, however, is that Hydro One has grown its EBIT by 14% over the past 12 months, making it better able to manage its debt. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the future profitability of the company will decide whether Hydro One can strengthen its balance sheet over time. So if you want to see what the pros think, you might find this free analyst earnings forecast report be interesting.
Finally, while the tax man loves accounting profits, lenders only accept cold hard cash. So we always look at how much of that EBIT is translated into free cash flow. Over the past three years, Hydro One reported free cash flow worth 3.1% of its EBIT, which is really quite low. That slack level of cash conversion undermines his ability to manage and pay off debt.
When we think about Hydro One’s attempt to manage its debt, based on its EBITDA, we are certainly not thrilled. But at least it’s pretty good at growing its EBIT; that’s encouraging. It’s also worth noting that Hydro One is part of the power supply industry, which is often considered quite defensive. In general, we think it’s fair to say that Hydro One has enough debt that there is real risk around its balance sheet. If all goes well, that should increase returns, but then again, the risk of permanent capital loss is increased by the debt. There is no doubt that we learn the most about debt from the balance sheet. But in the end, any business can contain risks that exist off-balance sheet. We have identified 3 warning signs with Hydro One (at least 2 that may be severe) , and understanding them should be part of your investment process.
When all is said and done, sometimes it’s easier to focus on businesses that don’t even need debt. Readers have access to a list of growth stocks with no net debt 100% free, straight away.
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This article from Simply Wall St is general in nature. It is not a recommendation to buy or sell stocks and does not take into account your objectives or your financial situation. We strive to provide you with long-term focused analysis powered by fundamental data. Please note that our analysis may not take into account the latest price-sensitive company announcements or quality material. Simply Wall St has no position in said stocks.
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