We Think MRV Engenharia e Participações (BVMF:MRVE3) Is Taking Some Risk With Its Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that MRV Engenharia e Participações S.A. (BVMF:MRVE3) does use debt in its business. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for MRV Engenharia e Participações

What Is MRV Engenharia e Participações's Net Debt?

The chart below, which you can click on for greater detail, shows that MRV Engenharia e Participações had R$4.89b in debt in June 2021; about the same as the year before. However, because it has a cash reserve of R$2.40b, its net debt is less, at about R$2.49b.

A Look At MRV Engenharia e Participações' Liabilities

According to the last reported balance sheet, MRV Engenharia e Participações had liabilities of R$4.06b due within 12 months, and liabilities of R$8.92b due beyond 12 months. Offsetting these obligations, it had cash of R$2.40b as well as receivables valued at R$2.04b due within 12 months. So it has liabilities totalling R$8.54b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of R$6.39b, 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. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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 2.6 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 32.6 is very high, suggesting that the interest expense on the debt is currently quite low. Also relevant is that MRV Engenharia e Participações has grown its EBIT by a very respectable 21% in the last year, thus enhancing its ability to pay down 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 MRV Engenharia e Participações can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, MRV Engenharia e Participações created free cash flow amounting to 13% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Neither MRV Engenharia e Participações's ability to handle its total liabilities nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. 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. 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. We've identified 3 warning signs with MRV Engenharia e Participações (at least 1 which can't be ignored) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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.

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