Is Ultrapar Participações (BVMF:UGPA3) A Risky Investment?

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 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 Ultrapar Participações S.A. (BVMF:UGPA3) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Ultrapar Participações

What Is Ultrapar Participações's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2020 Ultrapar Participações had debt of R$17.0b, up from R$15.1b in one year. However, it does have R$5.95b in cash offsetting this, leading to net debt of about R$11.0b.

A Look At Ultrapar Participações's Liabilities

According to the last reported balance sheet, Ultrapar Participações had liabilities of R$5.44b due within 12 months, and liabilities of R$18.1b due beyond 12 months. Offsetting this, it had R$5.95b in cash and R$5.15b in receivables that were due within 12 months. So its liabilities total R$12.4b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of R$20.6b, so it does suggest shareholders should keep an eye on Ultrapar Participações's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).

Ultrapar Participações's debt is 3.8 times its EBITDA, and its EBIT cover its interest expense 3.3 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Even more troubling is the fact that Ultrapar Participações actually let its EBIT decrease by 5.7% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Ultrapar Participações 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, 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, Ultrapar Participações produced sturdy free cash flow equating to 65% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Neither Ultrapar Participações's ability handle its debt, based on its EBITDA, nor its interest cover gave us confidence in its ability to take on more debt. But we do take some comfort from its conversion of EBIT to free cash flow. Taking the abovementioned factors together we do think Ultrapar Participações's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Consider risks, for instance. Every company has them, and we've spotted 5 warning signs for Ultrapar Participações you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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. 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.
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