Ultrapar Participações (BVMF:UGPA3) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Ultrapar Participações S.A. (BVMF:UGPA3) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. 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?

As you can see below, Ultrapar Participações had R$12.7b of debt, at June 2023, which is about the same as the year before. You can click the chart for greater detail. However, it also had R$5.72b in cash, and so its net debt is R$6.98b.

How Healthy Is Ultrapar Participações' Balance Sheet?

We can see from the most recent balance sheet that Ultrapar Participações had liabilities of R$8.44b falling due within a year, and liabilities of R$13.2b due beyond that. Offsetting this, it had R$5.72b in cash and R$6.32b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$9.64b.

Ultrapar Participações has a market capitalization of R$20.4b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Ultrapar Participações has a quite reasonable net debt to EBITDA multiple of 2.2, its interest cover seems weak, at 2.1. This does suggest the company is paying fairly high interest rates. In any case, it's safe to say the company has meaningful debt. Importantly Ultrapar Participações's EBIT was essentially flat over the last twelve months. Ideally it can diminish its debt load by kick-starting earnings growth. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Ultrapar Participações recorded free cash flow of 50% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Ultrapar Participações's interest cover was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its conversion of EBIT to free cash flow is relatively strong. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Ultrapar Participações (at least 1 which is significant) , and understanding them should be part of your investment process.

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.