Localiza Rent a Car (BVMF:RENT3) Has A Somewhat Strained Balance Sheet

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We can see that Localiza Rent a Car S.A. (BVMF:RENT3) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

See our latest analysis for Localiza Rent a Car

What Is Localiza Rent a Car's Debt?

As you can see below, at the end of June 2020, Localiza Rent a Car had R$11.3b of debt, up from R$6.86b a year ago. Click the image for more detail. However, because it has a cash reserve of R$3.13b, its net debt is less, at about R$8.17b.

A Look At Localiza Rent a Car's Liabilities

According to the last reported balance sheet, Localiza Rent a Car had liabilities of R$2.10b due within 12 months, and liabilities of R$11.5b due beyond 12 months. Offsetting this, it had R$3.13b in cash and R$884.0m in receivables that were due within 12 months. So its liabilities total R$9.6b more than the combination of its cash and short-term receivables.

Localiza Rent a Car has a market capitalization of R$38.2b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

With a net debt to EBITDA ratio of 5.3, it's fair to say Localiza Rent a Car does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 3.1 times, suggesting it can responsibly service its obligations. The good news is that Localiza Rent a Car improved its EBIT by 3.9% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. 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 Localiza Rent a Car can strengthen its balance sheet over time. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Localiza Rent a Car burned a lot of cash. 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 Localiza Rent a Car'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 its EBIT growth rate is not so bad. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Localiza Rent a Car stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. To that end, you should learn about the 3 warning signs we've spotted with Localiza Rent a Car (including 2 which is make us uncomfortable) .

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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