Is Companhia Brasileira de Distribuição (BVMF:PCAR3) 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. Importantly, Companhia Brasileira de Distribuição (BVMF:PCAR3) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

Check out our latest analysis for Companhia Brasileira de Distribuição

What Is Companhia Brasileira de Distribuição's Net Debt?

The image below, which you can click on for greater detail, shows that Companhia Brasileira de Distribuição had debt of R$8.70b at the end of June 2022, a reduction from R$9.80b over a year. However, because it has a cash reserve of R$3.92b, its net debt is less, at about R$4.78b.

A Look At Companhia Brasileira de Distribuição's Liabilities

We can see from the most recent balance sheet that Companhia Brasileira de Distribuição had liabilities of R$14.6b falling due within a year, and liabilities of R$14.7b due beyond that. On the other hand, it had cash of R$3.92b and R$5.58b worth of receivables due within a year. So it has liabilities totalling R$19.8b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the R$5.76b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Companhia Brasileira de Distribuição would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Even though Companhia Brasileira de Distribuição's debt is only 1.7, its interest cover is really very low at 1.4. This does suggest the company is paying fairly high interest rates. Either way there's no doubt the stock is using meaningful leverage. The bad news is that Companhia Brasileira de Distribuição saw its EBIT decline by 11% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. 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 Companhia Brasileira de Distribuição can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Companhia Brasileira de Distribuição recorded free cash flow worth 77% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

To be frank both Companhia Brasileira de Distribuição's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. We're quite clear that we consider Companhia Brasileira de Distribuição to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 4 warning signs we've spotted with Companhia Brasileira de Distribuição (including 1 which is a bit unpleasant) .

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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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.