Is WEG (BVMF:WEGE3) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, WEG S.A. (BVMF:WEGE3) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for WEG

What Is WEG's Debt?

As you can see below, at the end of March 2022, WEG had R$3.08b of debt, up from R$1.75b a year ago. Click the image for more detail. But on the other hand it also has R$3.26b in cash, leading to a R$186.0m net cash position.

How Healthy Is WEG's Balance Sheet?

According to the last reported balance sheet, WEG had liabilities of R$9.30b due within 12 months, and liabilities of R$2.08b due beyond 12 months. Offsetting this, it had R$3.26b in cash and R$5.24b in receivables that were due within 12 months. So its liabilities total R$2.88b more than the combination of its cash and short-term receivables.

Since publicly traded WEG shares are worth a very impressive total of R$111.5b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, WEG also has more cash than debt, so we're pretty confident it can manage its debt safely.

In addition to that, we're happy to report that WEG has boosted its EBIT by 36%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine WEG's ability to maintain a healthy balance sheet going forward. 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. WEG may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, WEG's free cash flow amounted to 48% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

While it is always sensible to look at a company's total liabilities, it is very reassuring that WEG has R$186.0m in net cash. And we liked the look of last year's 36% year-on-year EBIT growth. So we don't think WEG's use of debt is risky. 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. We've identified 1 warning sign with WEG , and understanding them should be part of your investment process.

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.