Vulcabras Azaleia (BVMF:VULC3) Takes On Some Risk With Its Use 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.' 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 note that Vulcabras Azaleia S.A. (BVMF:VULC3) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Vulcabras Azaleia

What Is Vulcabras Azaleia's Net Debt?

As you can see below, at the end of March 2021, Vulcabras Azaleia had R$311.6m of debt, up from R$81.0m a year ago. Click the image for more detail. However, because it has a cash reserve of R$146.8m, its net debt is less, at about R$164.8m.

How Healthy Is Vulcabras Azaleia's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Vulcabras Azaleia had liabilities of R$334.0m due within 12 months and liabilities of R$227.6m due beyond that. Offsetting this, it had R$146.8m in cash and R$515.7m in receivables that were due within 12 months. So it can boast R$100.9m more liquid assets than total liabilities.

This surplus suggests that Vulcabras Azaleia has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

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

Vulcabras Azaleia's net debt is only 1.0 times its EBITDA. And its EBIT covers its interest expense a whopping 12.0 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Vulcabras Azaleia's saving grace is its low debt levels, because its EBIT has tanked 24% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 Vulcabras Azaleia 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Vulcabras Azaleia burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

While Vulcabras Azaleia's conversion of EBIT to free cash flow makes us cautious about it, its track record of (not) growing its EBIT is no better. But on the brighter side of life, its interest cover leaves us feeling more frolicsome. Looking at all the angles mentioned above, it does seem to us that Vulcabras Azaleia is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For example - Vulcabras Azaleia has 2 warning signs we think you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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