Legendary fund manager Li Lu (who Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. So it can be obvious that you need to consider debt, when you think about how risky a given stock is, because too much debt can sink a business. We can see that The Southern Company (NYSE: SO) uses debt in its business. But does this debt worry shareholders?
What risk does debt entail?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. Of course, many companies use debt to finance their growth without negative consequences. When we think of a business’s use of debt, we first look at cash flow and debt together.
Check out our latest analysis for the South
What is the debt of the South?
You can click on the graph below for historical numbers, but it shows that as of March 2021, Southern had $ 51.4 billion in debt, an increase from $ 47.8 billion, year on year. . On the other hand, it has $ 1.77 billion in cash, resulting in net debt of around $ 49.6 billion.
How strong is Southern’s balance sheet?
We can see from the most recent balance sheet that Southern had liabilities of US $ 11.6 billion maturing within one year and liabilities of US $ 80.4 billion maturing beyond that. In return, he had $ 1.77 billion in cash and $ 3.03 billion in receivables due within 12 months. Its liabilities therefore total $ 87.2 billion more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company’s huge US $ 66.8 billion market cap, you might well be inclined to take a close look at the balance sheet. Hypothetically, an extremely large dilution would be required if the company was forced to repay its debts by raising capital at the current share price.
In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
With a net debt to EBITDA ratio of 5.2, it’s fair to say that Southern has significant debt. However, its interest coverage of 3.1 is reasonably strong, which is a good sign. Given the leverage, it is not ideal that Southern’s EBIT has been fairly stable over the past twelve months. The balance sheet is clearly the area you need to focus on when analyzing debt. But it is future earnings, more than anything, that will determine Southern’s ability to maintain a healthy balance sheet going forward. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. We must therefore clearly check whether this EBIT generates a corresponding free cash flow. Southern has spent a lot of money over the past three years. While this may be the result of spending on growth, it makes debt much riskier.
Our point of view
To be frank, Southern’s net debt to EBITDA and track record of converting EBIT to free cash flow makes us rather uncomfortable with its debt levels. That said, his ability to increase his EBIT is not that much of a concern. It should also be noted that electric utility companies like Southern generally use debt without a problem. We’re pretty clear that we consider Southern to be really quite risky, because of the health of its balance sheet. We are therefore almost as wary of this stock as a hungry kitten falls into its owner’s fish pond: once bitten, twice shy, as they say. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks lie on the balance sheet – far from it. For example, we discovered 2 warning signs for the South (1 cannot be ignored!) Which you should be aware of before investing here.
If, after all of this, you’re more interested in a fast-growing company with a strong balance sheet, take a quick look at our list of cash net growth stocks.
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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.
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