Arezzo Indústria e Comércio (BVMF:ARZZ3) Seems To Use Debt Quite Sensibly

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.' 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. As with many other companies Arezzo Indústria e Comércio S.A. (BVMF:ARZZ3) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Arezzo Indústria e Comércio

How Much Debt Does Arezzo Indústria e Comércio Carry?

As you can see below, at the end of September 2023, Arezzo Indústria e Comércio had R$1.09b of debt, up from R$411.5m a year ago. Click the image for more detail. On the flip side, it has R$643.6m in cash leading to net debt of about R$448.9m.

How Strong Is Arezzo Indústria e Comércio's Balance Sheet?

According to the last reported balance sheet, Arezzo Indústria e Comércio had liabilities of R$2.17b due within 12 months, and liabilities of R$551.9m due beyond 12 months. Offsetting this, it had R$643.6m in cash and R$1.17b in receivables that were due within 12 months. So it has liabilities totalling R$908.1m more than its cash and near-term receivables, combined.

Since publicly traded Arezzo Indústria e Comércio shares are worth a total of R$6.39b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

Looking at its net debt to EBITDA of 0.77 and interest cover of 5.7 times, it seems to us that Arezzo Indústria e Comércio is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. If Arezzo Indústria e Comércio can keep growing EBIT at last year's rate of 14% over the last year, then it will find its debt load easier to manage. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Arezzo Indústria e Comércio can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Arezzo Indústria e Comércio created free cash flow amounting to 6.2% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Both Arezzo Indústria e Comércio's ability to handle its debt, based on its EBITDA, and its EBIT growth rate gave us comfort that it can handle its debt. On the other hand, its conversion of EBIT to free cash flow makes us a little less comfortable about its debt. When we consider all the elements mentioned above, it seems to us that Arezzo Indústria e Comércio is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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 2 warning signs we've spotted with Arezzo Indústria e Comércio .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.