Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that CMS Energy Corporation (NYSE:CMS) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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 CMS Energy Carry?

The image below, which you can click on for greater detail, shows that at June 2024 CMS Energy had debt of US$15.8b, up from US$15.1b in one year. However, it does have US$699.0m in cash offsetting this, leading to net debt of about US$15.1b.

How Healthy Is CMS Energy's Balance Sheet?

We can see from the most recent balance sheet that CMS Energy had liabilities of US$1.76b falling due within a year, and liabilities of US$24.1b due beyond that. Offsetting this, it had US$699.0m in cash and US$898.0m in receivables that were due within 12 months. So it has liabilities totalling US$24.2b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's huge US$19.6b 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.

CMS Energy shareholders face the double whammy of a high net debt to EBITDA ratio (5.5), and fairly weak interest coverage, since EBIT is just 2.4 times the interest expense. This means we'd consider it to have a heavy debt load. On the other hand, CMS Energy grew its EBIT by 21% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. 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 CMS 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, CMS Energy saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both CMS 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. It's also worth noting that CMS Energy is in the Integrated Utilities industry, which is often considered to be quite defensive. We're quite clear that we consider CMS Energy to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. We've identified 3 warning signs with CMS Energy (at least 1 which is potentially serious) , and understanding them should be part of your investment process.

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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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.