Does Construtora Tenda (BVMF:TEND3) Have A Healthy Balance Sheet?

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.' 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 Construtora Tenda S.A. (BVMF:TEND3) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Construtora Tenda

What Is Construtora Tenda's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Construtora Tenda had debt of R$1.15b, up from R$744.8m in one year. However, it does have R$1.01b in cash offsetting this, leading to net debt of about R$143.4m.

How Strong Is Construtora Tenda's Balance Sheet?

We can see from the most recent balance sheet that Construtora Tenda had liabilities of R$1.04b falling due within a year, and liabilities of R$1.59b due beyond that. On the other hand, it had cash of R$1.01b and R$616.2m worth of receivables due within a year. So it has liabilities totalling R$1.00b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Construtora Tenda has a market capitalization of R$2.93b, 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 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.

Construtora Tenda's net debt is only 0.46 times its EBITDA. And its EBIT easily covers its interest expense, being 30.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that Construtora Tenda saw its EBIT decline by 2.9% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Construtora Tenda 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 we always check how much of that EBIT is translated into free cash flow. In the last three years, Construtora Tenda's free cash flow amounted to 39% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Both Construtora Tenda's ability to to cover its interest expense with its EBIT and its net debt to EBITDA gave us comfort that it can handle its debt. On the other hand, its EBIT growth rate makes us a little less comfortable about its debt. When we consider all the elements mentioned above, it seems to us that Construtora Tenda is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. Be aware that Construtora Tenda is showing 2 warning signs in our investment analysis , and 1 of those is potentially serious...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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