Restoque Comércio e Confecções de Roupas (BVMF:LLIS3) Seems To Be Using A Lot Of Debt

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 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. We can see that Restoque Comércio e Confecções de Roupas S.A. (BVMF:LLIS3) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Restoque Comércio e Confecções de Roupas

What Is Restoque Comércio e Confecções de Roupas's Debt?

As you can see below, at the end of September 2021, Restoque Comércio e Confecções de Roupas had R$1.56b of debt, up from R$1.45b a year ago. Click the image for more detail. However, it also had R$58.9m in cash, and so its net debt is R$1.50b.

A Look At Restoque Comércio e Confecções de Roupas' Liabilities

Zooming in on the latest balance sheet data, we can see that Restoque Comércio e Confecções de Roupas had liabilities of R$428.9m due within 12 months and liabilities of R$1.56b due beyond that. Offsetting this, it had R$58.9m in cash and R$152.4m in receivables that were due within 12 months. So it has liabilities totalling R$1.78b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the R$99.8m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Restoque Comércio e Confecções de Roupas would likely require a major re-capitalisation if it had to pay its creditors today.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Restoque Comércio e Confecções de Roupas has a debt to EBITDA ratio of 2.6 and its EBIT covered its interest expense 5.0 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. We also note that Restoque Comércio e Confecções de Roupas improved its EBIT from a last year's loss to a positive R$586m. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Restoque Comércio e Confecções de Roupas 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Restoque Comércio e Confecções de Roupas reported free cash flow worth 9.6% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Mulling over Restoque Comércio e Confecções de Roupas's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least its EBIT growth rate is not so bad. We're quite clear that we consider Restoque Comércio e Confecções de Roupas to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. Case in point: We've spotted 3 warning signs for Restoque Comércio e Confecções de Roupas you should be aware of, and 1 of them is concerning.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.