Petroreconcavo (BVMF:RECV3) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Petroreconcavo S.A. (BVMF:RECV3) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Petroreconcavo

What Is Petroreconcavo's Debt?

The image below, which you can click on for greater detail, shows that at December 2023 Petroreconcavo had debt of R$903.0m, up from R$655.6m in one year. On the flip side, it has R$507.4m in cash leading to net debt of about R$395.6m.

How Healthy Is Petroreconcavo's Balance Sheet?

The latest balance sheet data shows that Petroreconcavo had liabilities of R$1.07b due within a year, and liabilities of R$1.25b falling due after that. On the other hand, it had cash of R$507.4m and R$594.5m worth of receivables due within a year. So its liabilities total R$1.21b more than the combination of its cash and short-term receivables.

Since publicly traded Petroreconcavo shares are worth a total of R$6.08b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).

Petroreconcavo's net debt is only 0.31 times its EBITDA. And its EBIT easily covers its interest expense, being 25.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Petroreconcavo's saving grace is its low debt levels, because its EBIT has tanked 46% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Petroreconcavo's ability to maintain a healthy balance sheet going forward. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Petroreconcavo reported free cash flow worth 5.0% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

While Petroreconcavo's EBIT growth rate has us nervous. To wit both its interest cover and net debt to EBITDA were encouraging signs. We think that Petroreconcavo'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. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Petroreconcavo that you should be aware of before investing here.

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.