Here's Why Ultrapar Participações (BVMF:UGPA3) Has A Meaningful Debt Burden

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.' 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 Ultrapar Participações S.A. (BVMF:UGPA3) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Ultrapar Participações

How Much Debt Does Ultrapar Participações Carry?

The image below, which you can click on for greater detail, shows that at March 2021 Ultrapar Participações had debt of R$18.6b, up from R$17.0b in one year. However, it also had R$7.49b in cash, and so its net debt is R$11.1b.

A Look At Ultrapar Participações' Liabilities

The latest balance sheet data shows that Ultrapar Participações had liabilities of R$9.22b due within a year, and liabilities of R$18.3b falling due after that. On the other hand, it had cash of R$7.49b and R$5.79b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$14.2b.

This is a mountain of leverage relative to its market capitalization of R$19.4b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Ultrapar Participações has a debt to EBITDA ratio of 4.2 and its EBIT covered its interest expense 3.8 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Even more troubling is the fact that Ultrapar Participações actually let its EBIT decrease by 8.2% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. 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 Ultrapar Participações 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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Ultrapar Participações actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Neither Ultrapar Participações's ability handle its debt, based on its EBITDA, nor its EBIT growth rate gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. When we consider all the factors discussed, it seems to us that Ultrapar Participações is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. Be aware that Ultrapar Participações is showing 3 warning signs in our investment analysis , and 1 of those is concerning...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. 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.
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