The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Avangrid, Inc. (NYSE:AGR) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.
See our latest analysis for Avangrid
How Much Debt Does Avangrid Carry?
The image below, which you can click on for greater detail, shows that at June 2022 Avangrid had debt of US$8.33b, up from US$7.79b in one year. On the flip side, it has US$411.0m in cash leading to net debt of about US$7.92b.NYSE:AGR Debt to Equity History September 24th 2022
A Look At Avangrid's Liabilities
Zooming in on the latest balance sheet data, we can see that Avangrid had liabilities of US$3.35b due within 12 months and liabilities of US$16.0b due beyond that. Offsetting this, it had US$411.0m in cash and US$1.32b in receivables that were due within 12 months. So it has liabilities totalling US$17.6b more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's massive market capitalization of US$17.5b, we think shareholders really should watch Avangrid's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). 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).
Avangrid has a debt to EBITDA ratio of 4.1 and its EBIT covered its interest expense 3.0 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Notably, Avangrid's EBIT was pretty flat over the last year, which isn't ideal given the debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Avangrid'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Avangrid saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Mulling over Avangrid's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least its EBIT growth rate is not so bad. We should also note that Electric Utilities industry companies like Avangrid commonly do use debt without problems. We're quite clear that we consider Avangrid to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with Avangrid .
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.