Is BrasilAgro - Companhia Brasileira de Propriedades Agrícolas (BVMF:AGRO3) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 BrasilAgro - Companhia Brasileira de Propriedades Agrícolas (BVMF:AGRO3) does use debt in its business. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 BrasilAgro - Companhia Brasileira de Propriedades Agrícolas

What Is BrasilAgro - Companhia Brasileira de Propriedades Agrícolas's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 BrasilAgro - Companhia Brasileira de Propriedades Agrícolas had debt of R$455.2m, up from R$257.4m in one year. However, because it has a cash reserve of R$224.2m, its net debt is less, at about R$231.1m.

How Healthy Is BrasilAgro - Companhia Brasileira de Propriedades Agrícolas' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that BrasilAgro - Companhia Brasileira de Propriedades Agrícolas had liabilities of R$429.9m due within 12 months and liabilities of R$507.3m due beyond that. Offsetting this, it had R$224.2m in cash and R$197.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$515.0m.

This deficit isn't so bad because BrasilAgro - Companhia Brasileira de Propriedades Agrícolas is worth R$1.53b, and thus could probably raise enough capital to shore up 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.

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).

BrasilAgro - Companhia Brasileira de Propriedades Agrícolas has net debt of just 1.1 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 7.2 times the interest expense over the last year. In addition to that, we're happy to report that BrasilAgro - Companhia Brasileira de Propriedades Agrícolas has boosted its EBIT by 71%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine BrasilAgro - Companhia Brasileira de Propriedades Agrícolas's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, BrasilAgro - Companhia Brasileira de Propriedades Agrícolas's free cash flow amounted to 26% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Happily, BrasilAgro - Companhia Brasileira de Propriedades Agrícolas's impressive EBIT growth rate implies it has the upper hand on its debt. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that BrasilAgro - Companhia Brasileira de Propriedades Agrícolas can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example - BrasilAgro - Companhia Brasileira de Propriedades Agrícolas has 2 warning signs we think you should be aware of.

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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