We Think Smartfit Escola de Ginástica e Dança (BVMF:SMFT3) Is Taking Some Risk With Its 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. Importantly, Smartfit Escola de Ginástica e Dança S.A. (BVMF:SMFT3) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Smartfit Escola de Ginástica e Dança

How Much Debt Does Smartfit Escola de Ginástica e Dança Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Smartfit Escola de Ginástica e Dança had R$5.18b of debt, an increase on R$3.46b, over one year. However, it also had R$2.97b in cash, and so its net debt is R$2.21b.

How Healthy 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$2.25b due within a year, and liabilities of R$8.86b falling due after that. On the other hand, it had cash of R$2.97b and R$976.9m worth of receivables due within a year. So its liabilities total R$7.17b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of R$10.2b, so it does suggest shareholders should keep an eye on Smartfit Escola de Ginástica e Dança's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Even though Smartfit Escola de Ginástica e Dança's debt is only 1.6, its interest cover is really very low at 1.7. This does suggest the company is paying fairly high interest rates. Either way there's no doubt the stock is using meaningful leverage. One way Smartfit Escola de Ginástica e Dança could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 17%, as it did over the last year. 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 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Smartfit Escola de Ginástica e Dança saw substantial negative free cash flow, in total. 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

To be frank both Smartfit Escola de Ginástica e Dança's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Smartfit Escola de Ginástica e Dança's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Smartfit Escola de Ginástica e Dança (of which 1 is potentially serious!) you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.