Arezzo Indústria e Comércio (BVMF:ARZZ3) Has A Pretty Healthy Balance Sheet

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Arezzo Indústria e Comércio S.A. (BVMF:ARZZ3) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Arezzo Indústria e Comércio

What Is Arezzo Indústria e Comércio's Debt?

The image below, which you can click on for greater detail, shows that at March 2023 Arezzo Indústria e Comércio had debt of R$1.06b, up from R$284.0m in one year. On the flip side, it has R$783.1m in cash leading to net debt of about R$277.0m.

A Look At Arezzo Indústria e Comércio's Liabilities

According to the last reported balance sheet, Arezzo Indústria e Comércio had liabilities of R$1.59b due within 12 months, and liabilities of R$800.4m due beyond 12 months. Offsetting these obligations, it had cash of R$783.1m as well as receivables valued at R$1.07b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$541.5m.

Given Arezzo Indústria e Comércio has a market capitalization of R$7.08b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Arezzo Indústria e Comércio has a low net debt to EBITDA ratio of only 0.58. And its EBIT easily covers its interest expense, being 15.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that Arezzo Indústria e Comércio saw its EBIT decline by 7.8% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Arezzo Indústria e Comércio'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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Arezzo Indústria e Comércio reported free cash flow worth 3.5% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

When it comes to the balance sheet, the standout positive for Arezzo Indústria e Comércio was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. To be specific, it seems about as good at converting EBIT to free cash flow as wet socks are at keeping your feet warm. When we consider all the factors mentioned above, we do feel a bit cautious about Arezzo Indústria e Comércio's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 2 warning signs we've spotted with Arezzo Indústria e Comércio (including 1 which is concerning) .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.