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. As with many other companies MGE Energy, Inc. (NASDAQ:MGEE) makes use of debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does MGE Energy Carry?
As you can see below, at the end of March 2021, MGE Energy had US$575.8m of debt, up from US$545.3m a year ago. Click the image for more detail. However, it does have US$40.2m in cash offsetting this, leading to net debt of about US$535.5m.
How Strong Is MGE Energy’s Balance Sheet?
We can see from the most recent balance sheet that MGE Energy had liabilities of US$183.8m falling due within a year, and liabilities of US$1.09b due beyond that. Offsetting these obligations, it had cash of US$40.2m as well as receivables valued at US$78.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.15b.
While this might seem like a lot, it is not so bad since MGE Energy has a market capitalization of US$2.73b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
MGE Energy’s debt is 2.7 times its EBITDA, and its EBIT cover its interest expense 5.7 times over. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. One way MGE Energy could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 12%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if MGE Energy can strengthen its balance sheet over time.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, MGE Energy saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
MGE Energy’s struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its EBIT growth rate is relatively strong. We should also note that Electric Utilities industry companies like MGE Energy commonly do use debt without problems. Taking the abovementioned factors together we do think MGE Energy’s debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet.