Here's Why M. Dias Branco Indústria e Comércio de Alimentos (BVMF:MDIA3) Can Manage Its Debt Responsibly

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 can see that M. Dias Branco S.A. Indústria e Comércio de Alimentos (BVMF:MDIA3) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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.

Our analysis indicates that MDIA3 is potentially undervalued!

What Is M. Dias Branco Indústria e Comércio de Alimentos's Net Debt?

As you can see below, M. Dias Branco Indústria e Comércio de Alimentos had R$1.88b of debt at June 2022, down from R$1.96b a year prior. However, it does have R$672.7m in cash offsetting this, leading to net debt of about R$1.21b.

A Look At M. Dias Branco Indústria e Comércio de Alimentos' Liabilities

The latest balance sheet data shows that M. Dias Branco Indústria e Comércio de Alimentos had liabilities of R$1.79b due within a year, and liabilities of R$2.23b falling due after that. Offsetting this, it had R$672.7m in cash and R$1.85b in receivables that were due within 12 months. So its liabilities total R$1.51b more than the combination of its cash and short-term receivables.

Given M. Dias Branco Indústria e Comércio de Alimentos has a market capitalization of R$13.9b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

M. Dias Branco Indústria e Comércio de Alimentos's net debt is only 1.3 times its EBITDA. And its EBIT easily covers its interest expense, being 122 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, M. Dias Branco Indústria e Comércio de Alimentos grew its EBIT by 32% over the last twelve months, and that growth will make it easier to handle its debt. 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 M. Dias Branco Indústria e Comércio de Alimentos 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 always check how much of that EBIT is translated into free cash flow. Over the most recent three years, M. Dias Branco Indústria e Comércio de Alimentos recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that M. Dias Branco Indústria e Comércio de Alimentos's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Looking at the bigger picture, we think M. Dias Branco Indústria e Comércio de Alimentos's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. Case in point: We've spotted 1 warning sign for M. Dias Branco Indústria e Comércio de Alimentos you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.