Stock Analysis

These 4 Measures Indicate That Smartfit Escola de Ginástica e Dança (BVMF:SMFT3) Is Using Debt Extensively

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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.' 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 can see that Smartfit Escola de Ginástica e Dança S.A. (BVMF:SMFT3) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. 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 think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Smartfit Escola de Ginástica e Dança

What Is Smartfit Escola de Ginástica e Dança's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Smartfit Escola de Ginástica e Dança had R$4.08b of debt, an increase on R$3.41b, over one year. On the flip side, it has R$2.34b in cash leading to net debt of about R$1.74b.

BOVESPA:SMFT3 Debt to Equity History May 10th 2024

How Strong Is Smartfit Escola de Ginástica e Dança's Balance Sheet?

The latest balance sheet data shows that Smartfit Escola de Ginástica e Dança had liabilities of R$2.23b due within a year, and liabilities of R$7.23b falling due after that. On the other hand, it had cash of R$2.34b and R$891.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$6.23b.

Smartfit Escola de Ginástica e Dança has a market capitalization of R$13.8b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Given net debt is only 0.99 times EBITDA, it is initially surprising to see that Smartfit Escola de Ginástica e Dança's EBIT has low interest coverage of 2.2 times. So while we're not necessarily alarmed we think that its debt is far from trivial. Pleasingly, Smartfit Escola de Ginástica e Dança is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 135% gain in the last twelve months. 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 Smartfit Escola de Ginástica e Dança 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last two years, Smartfit Escola de Ginástica e Dança burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Smartfit Escola de Ginástica e Dança's conversion of EBIT to free cash flow and interest cover definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. We think that Smartfit Escola de Ginástica e Dança's debt does make it a bit risky, after considering the aforementioned data points together. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Smartfit Escola de Ginástica e Dança is showing 2 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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.

Valuation is complex, but we're helping make it simple.

Find out whether Smartfit Escola de Ginástica e Dança is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

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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.