These 4 Measures Indicate That 3R Petroleum Óleo e Gás (BVMF:BRAV3) Is Using Debt Extensively

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 can see that 3R Petroleum Óleo e Gás S.A. (BVMF:BRAV3) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for 3R Petroleum Óleo e Gás

What Is 3R Petroleum Óleo e Gás's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 3R Petroleum Óleo e Gás had R$11.2b of debt, an increase on R$8.14b, over one year. However, it also had R$1.58b in cash, and so its net debt is R$9.57b.

How Healthy Is 3R Petroleum Óleo e Gás' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that 3R Petroleum Óleo e Gás had liabilities of R$3.01b due within 12 months and liabilities of R$13.7b due beyond that. Offsetting these obligations, it had cash of R$1.58b as well as receivables valued at R$830.0m due within 12 months. So its liabilities total R$14.3b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the R$8.10b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, 3R Petroleum Óleo e Gás would likely require a major re-capitalisation if it had to pay its creditors today.

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).

3R Petroleum Óleo e Gás has a debt to EBITDA ratio of 3.1 and its EBIT covered its interest expense 3.0 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. However, it should be some comfort for shareholders to recall that 3R Petroleum Óleo e Gás actually grew its EBIT by a hefty 530%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. 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 3R Petroleum Óleo e Gás 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, 3R Petroleum Óleo e Gás 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

On the face of it, 3R Petroleum Óleo e Gás'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 it's pretty decent at growing its EBIT; that's encouraging. We're quite clear that we consider 3R Petroleum Óleo e Gás 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. 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 instance, we've identified 2 warning signs for 3R Petroleum Óleo e Gás (1 can't be ignored) you should be aware of.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.