Warren Buffett said: “Volatility is far from synonymous with risk”. It is only natural to consider a company’s balance sheet when looking at its level of risk, as debt is often involved when a business collapses. We can see that Snam SpA (ILO: SRG) uses debt in its activities. But the real question is whether this debt makes the business risky.

What risk does debt entail?

Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own cash flow. If things really go wrong, lenders can take over the business. However, a more common (but still painful) scenario is that he has to raise new equity at low cost, thereby constantly diluting shareholders. That said, the most common situation is where a business manages its debt reasonably well – and to its own advantage. When we think of a business’s use of debt, we first look at cash flow and debt together.

See our latest review for Snam

What is Snam’s net debt?

As you can see below, Snam had € 15.7 billion in debt, as of June 2021, which is roughly the same as the year before. You can click on the graph for more details. However, he also had € 1.63 billion in cash, so his net debt is € 14.1 billion.

Is Snam’s track record healthy?

According to the last published balance sheet, Snam had liabilities of 5.50 billion euros within 12 months and liabilities of 10.5 billion euros due beyond 12 months. In compensation for these obligations, he had cash of € 1.63 billion as well as receivables valued at € 5.00 million within 12 months. Its liabilities thus exceed the sum of its cash and its (short-term) receivables by € 14.3 billion.

This deficit is considerable compared to its very large market capitalization of 16.7 billion euros, so he suggests shareholders keep an eye on the use of debt by Snam. This suggests that shareholders would be heavily diluted if the company needed to consolidate its balance sheet quickly.

We use two main ratios to tell us about leverage versus earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.

As it turns out, Snam has a rather worrying net debt to EBITDA ratio of 6.3 but very strong interest coverage of 17.0. So either he has access to very cheap long-term debt or his interest charges will go up! Notably, Snam’s EBIT has been fairly stable over the past year. Ideally, he can reduce his debt by starting profit growth. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Snam can strengthen its balance sheet over time. So if you are focused on the future you can check out this free report showing analysts’ earnings forecasts.

Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Over the past three years, Snam has created a free cash flow of 18% 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

We would go so far as to say that Snam’s net debt to EBITDA was disappointing. But on the bright side, his interest coverage is a good sign and makes us more optimistic. It should also be noted that Snam is in the gas utility industry, which is often viewed as quite defensive. Once we consider all of the above factors together it seems like Snam’s debt makes him a bit risky. Some people like this kind of risk, but we are aware of the potential pitfalls, so we would probably prefer him to carry less debt. The balance sheet is clearly the area you need to focus on when analyzing debt. However, not all investment risks lie on the balance sheet – far from it. To this end, you should inquire about the 2 warning signs we spotted it with Snam (including 1 which makes us a little uncomfortable).

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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