David Iben said it well when he said: “Volatility is not a risk that interests us. What matters to us is to avoid the permanent loss of capital. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. We can see that SSE plc (LON:SSE) uses debt in its business. But the real question is whether this debt makes the business risky.
When is debt a problem?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. If things go really bad, lenders can take over the business. 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, debt can be an important tool in businesses, especially capital-intensive businesses. When we look at debt levels, we first consider cash and debt levels, together.
Discover our latest analysis for SSE
What is SSE’s debt?
You can click on the chart below for historical figures, but it shows SSE had £8.67bn of debt in March 2022, up from £9.50bn a year earlier. However, as he has a cash reserve of £1.05 billion, his net debt is lower at around £7.62 billion.
How strong is SSE’s balance sheet?
According to the latest published balance sheet, SSE had liabilities of £4.66bn due within 12 months and liabilities of £11.9bn due beyond 12 months. As compensation for these obligations, it had cash of £1.05 billion as well as receivables valued at £2.22 billion and due within 12 months. It therefore has liabilities totaling £13.3 billion more than its cash and short-term receivables, combined.
This shortfall is sizable compared to its very large market capitalization of £18.6bn, so it suggests shareholders should keep an eye on SSE’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
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 ).
We would say that SSE’s moderate net debt to EBITDA ratio (1.9) indicates caution in leverage. And its towering EBIT of 11.5 times its interest expense means that the debt burden is as light as a peacock feather. It should be noted that SSE’s EBIT has jumped like bamboo after rain, gaining 88% over the last twelve months. This will make it easier to manage your debt. The balance sheet is clearly the area to focus on when analyzing debt. But it is future earnings, more than anything, that will determine SSE’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a company can only repay its debts with cold hard cash, not with book profits. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, SSE has had free cash flow of 15% of its EBIT, which is really quite low. This low level of cash conversion compromises its ability to manage and repay its debt.
Our point of view
SSE’s ability to grow its EBIT and its interest coverage has reinforced our ability to manage its debt. On the other hand, its conversion of EBIT into free cash flow makes us a little less comfortable about its debt. We also note that companies in the electric utility sector like SSE generally use debt without issue. Given this range of data points, we believe SSE is in a good position to manage its debt levels. That said, the charge is heavy enough that we recommend that any shareholder keep a close eye on it. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks reside on the balance sheet, far from it. To do this, you need to find out about the 4 warning signs we spotted some with SSE (including 2 that are potentially serious).
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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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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