Does Petro Rio (BVMF:PRIO3) Have A Healthy Balance Sheet?

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.' 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. Importantly, Petro Rio S.A. (BVMF:PRIO3) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

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What Is Petro Rio's Debt?

The image below, which you can click on for greater detail, shows that at September 2022 Petro Rio had debt of R$7.95b, up from R$3.42b in one year. However, it does have R$9.29b in cash offsetting this, leading to net cash of R$1.34b.

How Strong Is Petro Rio's Balance Sheet?

We can see from the most recent balance sheet that Petro Rio had liabilities of R$1.42b falling due within a year, and liabilities of R$9.26b due beyond that. Offsetting these obligations, it had cash of R$9.29b as well as receivables valued at R$1.13b due within 12 months. So its liabilities total R$260.4m more than the combination of its cash and short-term receivables.

This state of affairs indicates that Petro Rio's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the R$29.8b company is short on cash, but still worth keeping an eye on the balance sheet. Despite its noteworthy liabilities, Petro Rio boasts net cash, so it's fair to say it does not have a heavy debt load!

Better yet, Petro Rio grew its EBIT by 118% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. 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 Petro Rio 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. Petro Rio may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Looking at the most recent three years, Petro Rio recorded free cash flow of 30% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing Up

We could understand if investors are concerned about Petro Rio's liabilities, but we can be reassured by the fact it has has net cash of R$1.34b. And it impressed us with its EBIT growth of 118% over the last year. So is Petro Rio's debt a risk? It doesn't seem so to us. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Petro Rio you should know about.

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.