Yahoo Finance Is Centrica (LON:CNA) Using Too Much Debt?
The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Centrica plc (LON:CNA) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
View our latest analysis for Centrica
What Is Centrica's Net Debt?
As you can see below, Centrica had UK£4.28b of debt at December 2021, down from UK£4.87b a year prior. However, its balance sheet shows it holds UK£5.06b in cash, so it actually has UK£781.0m net cash.
How Strong Is Centrica's Balance Sheet?
According to the last reported balance sheet, Centrica had liabilities of UK£18.0b due within 12 months, and liabilities of UK£6.36b due beyond 12 months. Offsetting these obligations, it had cash of UK£5.06b as well as receivables valued at UK£4.88b due within 12 months. So it has liabilities totalling UK£14.4b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the UK£4.50b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Centrica would probably need a major re-capitalization if its creditors were to demand repayment. Given that Centrica has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.
Shareholders should be aware that Centrica's EBIT was down 87% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Centrica'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Centrica has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, Centrica recorded free cash flow worth 56% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Summing up
Although Centrica's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of UK£781.0m. Despite its cash we think that Centrica seems to struggle to handle its total liabilities, so we are wary of the stock. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Centrica you should be aware of, and 1 of them can't be ignored.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.
