Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. Importantly, Dominion Energy, Inc. (NYSE:D) does carry debt. But should shareholders be worried about its use of debt?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Dominion Energy's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2022 Dominion Energy had US$45.8b of debt, an increase on US$39.8b, over one year. On the flip side, it has US$2.32b in cash leading to net debt of about US$43.5b.
A Look At Dominion Energy's Liabilities
We can see from the most recent balance sheet that Dominion Energy had liabilities of US$13.2b falling due within a year, and liabilities of US$62.2b due beyond that. On the other hand, it had cash of US$2.32b and US$2.52b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$70.5b.
When you consider that this deficiency exceeds the company's huge US$67.6b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Dominion Energy has a rather high debt to EBITDA ratio of 5.9 which suggests a meaningful debt load. However, its interest coverage of 4.5 is reasonably strong, which is a good sign. We note that Dominion Energy grew its EBIT by 23% in the last year, and that should make it easier to pay down debt, going forward. 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 Dominion Energy can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
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. During the last three years, Dominion Energy burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Dominion Energy's net debt to EBITDA and its track record of converting EBIT to free cash flow 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 Integrated Utilities industry companies like Dominion Energy commonly do use debt without problems. Looking at the bigger picture, it seems clear to us that Dominion Energy's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 5 warning signs for Dominion Energy (2 shouldn't be ignored) you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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