Is Grendene (BVMF:GRND3) 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.' 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. As with many other companies Grendene S.A. (BVMF:GRND3) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Grendene

What Is Grendene's Debt?

You can click the graphic below for the historical numbers, but it shows that Grendene had R$9.82m of debt in December 2020, down from R$95.2m, one year before. But on the other hand it also has R$1.50b in cash, leading to a R$1.49b net cash position.

How Strong Is Grendene's Balance Sheet?

We can see from the most recent balance sheet that Grendene had liabilities of R$351.0m falling due within a year, and liabilities of R$94.5m due beyond that. Offsetting this, it had R$1.50b in cash and R$1.37b in receivables that were due within 12 months. So it actually has R$2.43b more liquid assets than total liabilities.

This luscious liquidity implies that Grendene's balance sheet is sturdy like a giant sequoia tree. Having regard to this fact, we think its balance sheet is as strong as an ox. Succinctly put, Grendene boasts net cash, so it's fair to say it does not have a heavy debt load!

Notably Grendene's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Grendene's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Grendene 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. Over the most recent three years, Grendene recorded free cash flow worth 71% 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.

Summing up

While it is always sensible to investigate a company's debt, in this case Grendene has R$1.49b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 71% of that EBIT to free cash flow, bringing in R$43m. So we don't think Grendene's use of debt is risky. 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. We've identified 1 warning sign with Grendene , 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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