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. We note that Romi S.A. (BVMF:ROMI3) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Romi Carry?
The image below, which you can click on for greater detail, shows that at June 2023 Romi had debt of R$814.1m, up from R$595.3m in one year. However, it does have R$284.0m in cash offsetting this, leading to net debt of about R$530.0m.
How Strong Is Romi's Balance Sheet?
The latest balance sheet data shows that Romi had liabilities of R$611.4m due within a year, and liabilities of R$554.9m falling due after that. Offsetting this, it had R$284.0m in cash and R$391.7m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$490.5m.
While this might seem like a lot, it is not so bad since Romi has a market capitalization of R$1.07b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
We'd say that Romi's moderate net debt to EBITDA ratio ( being 1.8), indicates prudence when it comes to debt. And its commanding EBIT of 255 times its interest expense, implies the debt load is as light as a peacock feather. Also relevant is that Romi has grown its EBIT by a very respectable 25% in the last year, thus enhancing its ability to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Romi will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Romi 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.
Romi's interest cover was a real positive on this analysis, as was its EBIT growth rate. In contrast, our confidence was undermined by its apparent struggle to convert EBIT to free cash flow. When we consider all the factors mentioned above, we do feel a bit cautious about Romi's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. For example, we've discovered 2 warning signs for Romi (1 makes us a bit uncomfortable!) that you should be aware of before investing here.
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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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.