Is Capital Power (TSE:CPX) using too much debt?

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Warren Buffett said: “Volatility is far from synonymous with risk. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. Like many other companies Capital Power Company (TSE:CPX) uses debt. But should shareholders worry about its use of debt?

When is debt a problem?

Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own 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. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.

Check out our latest analysis for Capital Power

What is Capital Power’s debt?

As you can see below, Capital Power had C$3.43 billion in debt as of December 2021, up from C$3.65 billion the previous year. However, it has C$387.0 million in cash to offset this, resulting in a net debt of approximately C$3.05 billion.

TSX:CPX Debt to Equity Historical April 7, 2022

How strong is Capital Power’s balance sheet?

Zooming in on the latest balance sheet data, we can see that Capital Power had liabilities of C$1.21 billion due within 12 months and liabilities of C$5.01 billion due beyond. In compensation for these obligations, it had cash of 387.0 million Canadian dollars as well as receivables valued at 432.0 million Canadian dollars and payable within 12 months. Thus, its liabilities total C$5.40 billion more than the combination of its cash and short-term receivables.

Given that this deficit is actually larger than the company’s market capitalization of C$4.89 billion, we think shareholders really should be watching Capital Power’s debt levels, like a parent watching their child do cycling for the first time. In the scenario where the company were to quickly clean up its balance sheet, it seems likely that shareholders would suffer significant dilution.

We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). 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 ).

While Capital Power’s debt to EBITDA ratio (3.6) suggests it is using some debt, its interest coverage is very low at 1.8, suggesting high leverage. This is largely due to the company’s large amortization charges, which no doubt means that its EBITDA is a very generous measure of earnings, and that its debt may be heavier than it first appears. on board. It seems clear that the cost of borrowing money is having a negative impact on shareholder returns lately. Worse still, Capital Power’s EBIT was down 23% from a year ago. If profits continue like this in the long term, there is an unimaginable chance of repaying this debt. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Capital Power can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.

Finally, while the taxman may love accounting profits, lenders only accept cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Capital Power has recorded free cash flow of 45% of its EBIT, which is lower than expected. This low cash conversion makes debt management more difficult.

Our point of view

To be frank, Capital Power’s interest coverage and history of (not) growing EBIT makes us rather uncomfortable with its level of leverage. But at least its EBIT to free cash flow conversion isn’t that bad. We are very clear that we consider Capital Power to be quite risky, given the health of its balance sheet. We are therefore almost as suspicious of this stock as a hungry kitten of 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 analyzing debt. But at the end of the day, every business can contain risks that exist outside of the balance sheet. For example, Capital Power has 4 warning signs (and 2 that we don’t like too much) that we think you should know about.

In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.

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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