These 4 Measures Indicate That Grendene (BVMF:GRND3) Is Using Debt Reasonably Well

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Grendene S.A. (BVMF:GRND3) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. 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?

The image below, which you can click on for greater detail, shows that Grendene had debt of R$14.0m at the end of September 2020, a reduction from R$76.2m over a year. But on the other hand it also has R$1.44b in cash, leading to a R$1.42b net cash position.

How Healthy Is Grendene's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Grendene had liabilities of R$272.5m due within 12 months and liabilities of R$83.1m due beyond that. Offsetting this, it had R$1.44b in cash and R$935.7m in receivables that were due within 12 months. So it actually has R$2.02b more liquid assets than total liabilities.

This surplus suggests that Grendene is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Grendene has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Grendene if management cannot prevent a repeat of the 27% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Grendene will need earnings to service that debt. 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, a company can only pay off debt with cold hard cash, not accounting profits. 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. Happily for any shareholders, Grendene actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Grendene has net cash of R$1.42b, as well as more liquid assets than liabilities. The cherry on top was that in converted 102% of that EBIT to free cash flow, bringing in R$314m. So we don't think Grendene's use of debt is risky. 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. Consider for instance, the ever-present spectre of investment risk. 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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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.
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