Is Construtora Tenda (BVMF:TEND3) Using Too Much Debt?

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.' 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. As with many other companies Construtora Tenda S.A. (BVMF:TEND3) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Construtora Tenda

What Is Construtora Tenda's Debt?

As you can see below, at the end of December 2020, Construtora Tenda had R$1.16b of debt, up from R$870.4m a year ago. Click the image for more detail. However, it also had R$978.9m in cash, and so its net debt is R$178.2m.

How Healthy Is Construtora Tenda's Balance Sheet?

The latest balance sheet data shows that Construtora Tenda had liabilities of R$1.22b due within a year, and liabilities of R$1.50b falling due after that. On the other hand, it had cash of R$978.9m and R$656.6m worth of receivables due within a year. So its liabilities total R$1.08b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Construtora Tenda is worth R$2.56b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Construtora Tenda has a low net debt to EBITDA ratio of only 0.53. And its EBIT easily covers its interest expense, being 21.5 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Construtora Tenda saw its EBIT drop by 2.1% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. There's no doubt that we learn most about debt from the balance sheet. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Construtora Tenda recorded free cash flow of 35% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

When it comes to the balance sheet, the standout positive for Construtora Tenda was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. Looking at all this data makes us feel a little cautious about Construtora Tenda's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Construtora Tenda is showing 3 warning signs in our investment analysis , and 1 of those can't be ignored...

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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