We Think MRV Engenharia e Participações (BVMF:MRVE3) Is Taking Some Risk With Its 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 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 MRV Engenharia e Participações S.A. (BVMF:MRVE3) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for MRV Engenharia e Participações

What Is MRV Engenharia e Participações's Debt?

As you can see below, at the end of March 2021, MRV Engenharia e Participações had R$5.01b of debt, up from R$4.09b a year ago. Click the image for more detail. However, because it has a cash reserve of R$2.27b, its net debt is less, at about R$2.75b.

How Healthy Is MRV Engenharia e Participações' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that MRV Engenharia e Participações had liabilities of R$3.84b due within 12 months and liabilities of R$8.91b due beyond that. On the other hand, it had cash of R$2.27b and R$2.04b worth of receivables due within a year. So its liabilities total R$8.44b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of R$8.42b, we think shareholders really should watch MRV Engenharia e Participações's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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.

MRV Engenharia e Participações's net debt is 3.1 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 24.0 is very high, suggesting that the interest expense on the debt is currently quite low. MRV Engenharia e Participações grew its EBIT by 5.3% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine MRV Engenharia e Participações's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, MRV Engenharia e Participações recorded free cash flow of 24% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

MRV Engenharia e Participações's level of total liabilities and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think MRV Engenharia e Participações's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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 example, we've discovered 2 warning signs for MRV Engenharia e Participações (1 is concerning!) that you should be aware of before investing here.

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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