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. Importantly, Iochpe-Maxion S.A. (BVMF:MYPK3) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 examine debt levels, we first consider both cash and debt levels, together.
What Is Iochpe-Maxion's Debt?
As you can see below, at the end of June 2021, Iochpe-Maxion had R$5.37b of debt, up from R$5.03b a year ago. Click the image for more detail. On the flip side, it has R$1.38b in cash leading to net debt of about R$3.99b.
How Strong Is Iochpe-Maxion's Balance Sheet?
We can see from the most recent balance sheet that Iochpe-Maxion had liabilities of R$4.78b falling due within a year, and liabilities of R$4.53b due beyond that. Offsetting these obligations, it had cash of R$1.38b as well as receivables valued at R$2.14b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$5.79b.
This deficit casts a shadow over the R$2.32b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Iochpe-Maxion would likely require a major re-capitalisation if it had to pay its creditors today.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Iochpe-Maxion has a debt to EBITDA ratio of 2.9 and its EBIT covered its interest expense 4.1 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. However, it should be some comfort for shareholders to recall that Iochpe-Maxion actually grew its EBIT by a hefty 1,052%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. 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 Iochpe-Maxion 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 always check how much of that EBIT is translated into free cash flow. Over the last three years, Iochpe-Maxion barely recorded positive free cash flow, in total. While many companies do operate at break-even, we prefer see substantial free cash flow, especially if a it already has dead.
We'd go so far as to say Iochpe-Maxion's level of total liabilities was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Iochpe-Maxion's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Iochpe-Maxion has 2 warning signs (and 1 which is a bit concerning) we think you should know about.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.
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