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.' 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. As with many other companies Sempra (NYSE:SRE) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Sempra's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Sempra had debt of US$31.9b, up from US$29.9b in one year. And it doesn't have much cash, so its net debt is about the same.

How Strong Is Sempra's Balance Sheet?

The latest balance sheet data shows that Sempra had liabilities of US$9.54b due within a year, and liabilities of US$45.5b falling due after that. Offsetting these obligations, it had cash of US$259.0m as well as receivables valued at US$2.10b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$52.7b.

When you consider that this deficiency exceeds the company's huge US$52.3b 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 use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 2.5 times and a disturbingly high net debt to EBITDA ratio of 6.3 hit our confidence in Sempra like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Another concern for investors might be that Sempra's EBIT fell 16% in the last year. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. 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 Sempra's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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, Sempra 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 Sempra's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. And furthermore, its interest cover also fails to instill confidence. It's also worth noting that Sempra is in the Integrated Utilities industry, which is often considered to be quite defensive. Taking into account all the aforementioned factors, it looks like Sempra has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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 2 warning signs for Sempra (1 can't be ignored) you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.