These 4 Measures Indicate That Arezzo Indústria e Comércio (BVMF:ARZZ3) Is Using Debt Reasonably Well

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 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?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Arezzo Indústria e Comércio

How Much Debt Does Arezzo Indústria e Comércio Carry?

As you can see below, Arezzo Indústria e Comércio had R$568.3m of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has R$297.2m in cash leading to net debt of about R$271.1m.

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

Zooming in on the latest balance sheet data, we can see that Arezzo Indústria e Comércio had liabilities of R$1.07b due within 12 months and liabilities of R$506.1m due beyond that. Offsetting this, it had R$297.2m in cash and R$750.1m in receivables that were due within 12 months. So it has liabilities totalling R$529.8m more than its cash and near-term receivables, combined.

Given Arezzo Indústria e Comércio has a market capitalization of R$7.35b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Arezzo Indústria e Comércio's net debt is only 0.60 times its EBITDA. And its EBIT covers its interest expense a whopping 22.2 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, Arezzo Indústria e Comércio grew its EBIT by 458% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. 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, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Arezzo Indústria e Comércio's free cash flow amounted to 50% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Happily, Arezzo Indústria e Comércio's impressive interest cover implies it has the upper hand on its debt. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Looking at the bigger picture, we think Arezzo Indústria e Comércio's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. Over time, share prices tend to follow earnings per share, so if you're interested in Arezzo Indústria e Comércio, you may well want to click here to check an interactive graph of its earnings per share history.

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.