Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘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. Importantly, Cosan Limited (NYSE:CZZ) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Cosan’s Net Debt?
The image below, which you can click on for greater detail, shows that at September 2019 Cosan had debt of R$27.8b, up from R$23.2b in one year. However, it also had R$9.35b in cash, and so its net debt is R$18.5b.
A Look At Cosan’s Liabilities
We can see from the most recent balance sheet that Cosan had liabilities of R$8.55b falling due within a year, and liabilities of R$38.8b due beyond that. Offsetting these obligations, it had cash of R$9.35b as well as receivables valued at R$3.20b due within 12 months. So it has liabilities totalling R$34.8b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the R$20.9b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Cosan would likely require a major re-capitalisation if it had to pay its creditors today.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Cosan’s debt is 2.9 times its EBITDA, and its EBIT cover its interest expense 4.2 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. Looking on the bright side, Cosan boosted its EBIT by a silky 56% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Cosan 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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Cosan recorded free cash flow worth a fulsome 80% of its EBIT, which is stronger than we’d usually expect. That puts it in a very strong position to pay down debt.
While Cosan’s level of total liabilities has us nervous. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. We think that Cosan’s debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. Consider for instance, the ever-present spectre of investment risk. We’ve identified 3 warning signs with Cosan (at least 1 which can’t be ignored) , and understanding them should be part of your investment process.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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