We believe that SSE (LON: SSE) can stay on top of its debt
Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say this when he says “The biggest risk in investing is not price volatility, but if you will suffer a loss. permanent capital “. When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. Above all, SSE plc (LON: SSE) is in debt. But the real question is whether this debt makes the business risky.
When is debt dangerous?
Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that he has to raise new equity at low cost, thereby constantly diluting shareholders. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.
See our latest analysis for ESS
How much debt does SSE have?
The image below, which you can click for more details, shows SSE owed Â£ 9.21bn in debt at the end of September 2021, down from Â£ 9.63bn over a year. However, as it has a cash reserve of Â£ 232.7million, its net debt is less, at around Â£ 8.97 billion.
How healthy is the SSE balance sheet?
The latest balance sheet data shows SSE had a liability of Â£ 5.57 billion maturing within one year, and a liability of Â£ 10.7 billion maturing after that. In return, he had Â£ 232.7 million in cash and Â£ 1.67 billion in receivables due within 12 months. Its liabilities therefore total Â£ 14.4 billion more than the combination of its cash and short-term receivables.
This shortfall is sizable compared to its very large market capitalization of Â£ 17.5 billion, so he suggests shareholders keep an eye on SSE’s use of debt. This suggests that shareholders would be greatly diluted if the company needed to consolidate its balance sheet quickly.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its earnings before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
SSE has a net debt to EBITDA of 2.6, which suggests that it uses good leverage to increase returns. But the high interest coverage of 9.9 suggests that he can easily pay off that debt. Fortunately, SSE is growing its EBIT faster than former Australian Prime Minister Bob Hawke, gaining 151% in the past twelve months. There is no doubt that we learn the most about debt from the balance sheet. But it is future profits, 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 Profit Forecast report interesting.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. Over the past three years, SSE has created free cash flow of 17% of its EBIT, a performance without interest. This low level of cash conversion undermines its ability to manage and repay its debts.
Our point of view
Based on our analysis, SSE’s EBIT growth rate should indicate that it will not have too many problems with its debt. But the other factors we noted above weren’t so encouraging. For example, it looks like he has to struggle a bit to convert EBIT to free cash flow. We would also like to note that companies in the electric utility sector like SSE generally use debt with no problem. Looking at all this data, we feel a little cautious about the debt levels of the ESS. While debt has its advantage in potential higher returns, we believe shareholders should definitely consider how leverage levels might make the stock riskier. When analyzing debt levels, the balance sheet is the obvious place to start. But at the end of the day, every business can contain risks that exist off the balance sheet. These risks can be difficult to spot. Every business has them, and we’ve spotted 5 warning signs of SSE (2 of which make us uncomfortable!) to know.
Of course, if you are the type of investor who prefers to buy stocks without going into debt, feel free to check out our exclusive list of cash net growth stocks today.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only 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 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 any of the stocks mentioned.