Is Cogna Educação (BVMF:COGN3) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. We note that Cogna Educação S.A. (BVMF:COGN3) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Cogna Educação

What Is Cogna Educação's Debt?

As you can see below, Cogna Educação had R$5.12b of debt at September 2022, down from R$6.24b a year prior. However, it does have R$2.19b in cash offsetting this, leading to net debt of about R$2.94b.

How Healthy Is Cogna Educação's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Cogna Educação had liabilities of R$3.88b due within 12 months and liabilities of R$9.01b due beyond that. Offsetting these obligations, it had cash of R$2.19b as well as receivables valued at R$2.08b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$8.63b.

The deficiency here weighs heavily on the R$4.16b 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, Cogna Educação would likely require a major re-capitalisation if it had to pay its creditors today.

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

Cogna Educação shareholders face the double whammy of a high net debt to EBITDA ratio (5.3), and fairly weak interest coverage, since EBIT is just 0.59 times the interest expense. This means we'd consider it to have a heavy debt load. One redeeming factor for Cogna Educação is that it turned last year's EBIT loss into a gain of R$356m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Cogna Educação's ability to maintain a healthy balance sheet going forward. 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 it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Cogna Educação 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

On the face of it, Cogna Educação's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. After considering the datapoints discussed, we think Cogna Educação has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Even though Cogna Educação lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.

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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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.