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 seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We can see that Entergy Corporation (NYSE:ETR) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Entergy’s Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2021 Entergy had US$25.6b of debt, an increase on US$22.1b, over one year. However, because it has a cash reserve of US$1.00b, its net debt is less, at about US$24.6b.

How Healthy Is Entergy’s Balance Sheet?

The latest balance sheet data shows that Entergy had liabilities of US$6.64b due within a year, and liabilities of US$40.7b falling due after that. On the other hand, it had cash of US$1.00b and US$1.53b worth of receivables due within a year. So its liabilities total US$44.8b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the US$21.4b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Entergy would probably need a major re-capitalization if its creditors were to demand repayment.

We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 6.0, it’s fair to say Entergy does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 5.6 times, suggesting it can responsibly service its obligations. If Entergy can keep growing EBIT at last year’s rate of 13% over the last year, then it will find its debt load easier to manage. 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 Entergy’s ability to maintain a healthy balance sheet going forward.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Entergy burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Entergy’s conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it’s pretty decent at growing its EBIT; that’s encouraging. We should also note that Electric Utilities industry companies like Entergy commonly do use debt without problems. Overall, it seems to us that Entergy’s balance sheet is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity.