Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.'  When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin.  Importantly, CenterPoint Energy, Inc. (NYSE:CNP) does carry debt.  But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does CenterPoint Energy Carry?

The image below, which you can click on for greater detail, shows that at March 2024 CenterPoint Energy had debt of US$19.1b, up from US$16.5b in one year.    However, it does have US$659.0m in cash offsetting this, leading to net debt of about US$18.5b.  

NYSE:CNP Debt to Equity History May 21st 2024

A Look At CenterPoint Energy's Liabilities

According to the last reported balance sheet, CenterPoint Energy had liabilities of US$3.43b due within 12 months, and liabilities of US$26.8b due beyond 12 months.   Offsetting this, it had US$659.0m in cash and US$1.25b in receivables that were due within 12 months.   So its liabilities outweigh the sum of its cash and (near-term) receivables by US$28.3b.  

When you consider that this deficiency exceeds the company's   huge  US$19.2b market capitalization, you might well be inclined to review the balance sheet intently.  In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.  

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover).  Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

CenterPoint Energy shareholders face the double whammy of a high net debt to EBITDA ratio (6.0), and fairly weak interest coverage, since EBIT is just 2.4 times the interest expense.  The debt burden here is substantial.        On a slightly more positive note, CenterPoint Energy grew its EBIT at 13% over the last year, further increasing its ability to manage debt.       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 CenterPoint Energy'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it.   So it's worth checking how much of that EBIT is backed by free cash flow.    During the last three years, CenterPoint Energy burned a lot of cash.  While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.  

Our View

On the face of it, CenterPoint Energy's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year.    But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic.       It's also worth noting that CenterPoint Energy is in the Integrated Utilities industry, which is often considered to be quite defensive.     Overall, it seems to us that CenterPoint Energy's balance sheet is really quite a risk to the business.  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.  But ultimately, every company can contain risks that exist outside of the balance sheet.   For example, we've discovered 2 warning signs for CenterPoint Energy (1 is potentially serious!) that you should be aware of before investing here.  

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.

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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.