Valid Soluções (BVMF:VLID3) Has A Somewhat Strained Balance Sheet

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We can see that Valid Soluções S.A. (BVMF:VLID3) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Valid Soluções

What Is Valid Soluções's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2020 Valid Soluções had R$989.2m of debt, an increase on R$833.5m, over one year. However, it does have R$333.9m in cash offsetting this, leading to net debt of about R$655.3m.

A Look At Valid Soluções's Liabilities

Zooming in on the latest balance sheet data, we can see that Valid Soluções had liabilities of R$707.4m due within 12 months and liabilities of R$868.0m due beyond that. On the other hand, it had cash of R$333.9m and R$526.2m worth of receivables due within a year. So its liabilities total R$715.4m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of R$790.3m, so it does suggest shareholders should keep an eye on Valid Soluções's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Valid Soluções's debt is 3.0 times its EBITDA, and its EBIT cover its interest expense 3.6 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. More concerning, Valid Soluções saw its EBIT drop by 9.4% in the last twelve months. 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 it is future earnings, more than anything, that will determine Valid Soluções's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Valid Soluções recorded free cash flow worth 68% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

At the end of the day, we're far from enamoured with Valid Soluções's ability to grow its EBIT or to handle its total liabilities. But in contrast to that, we were impressed by its conversion of EBIT to free cash flow. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Valid Soluções stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. To that end, you should be aware of the 5 warning signs we've spotted with Valid Soluções .

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. 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. Thank you for reading.