Does Guararapes Confecções (BVMF:GUAR3) Have A 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. Importantly, Guararapes Confecções S.A. (BVMF:GUAR3) does carry 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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Guararapes Confecções

What Is Guararapes Confecções's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Guararapes Confecções had R$3.64b of debt, an increase on R$3.47b, over one year. However, it does have R$1.27b in cash offsetting this, leading to net debt of about R$2.37b.

How Healthy Is Guararapes Confecções' Balance Sheet?

We can see from the most recent balance sheet that Guararapes Confecções had liabilities of R$5.83b falling due within a year, and liabilities of R$3.15b due beyond that. Offsetting these obligations, it had cash of R$1.27b as well as receivables valued at R$5.71b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$2.00b.

While this might seem like a lot, it is not so bad since Guararapes Confecções has a market capitalization of R$4.60b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

While we wouldn't worry about Guararapes Confecções's net debt to EBITDA ratio of 4.3, we think its super-low interest cover of 1.0 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. On a slightly more positive note, Guararapes Confecções grew its EBIT at 18% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Guararapes Confecções can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Guararapes Confecções recorded free cash flow worth 78% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Based on what we've seen Guararapes Confecções is not finding it easy, given its interest cover, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to convert EBIT to free cash flow is pretty flash. When we consider all the elements mentioned above, it seems to us that Guararapes Confecções is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for Guararapes Confecções (1 makes us a bit uncomfortable) you should be aware of.

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.