Is São Martinho (BVMF:SMTO3) A Risky Investment?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that São Martinho S.A. (BVMF:SMTO3) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for São Martinho

How Much Debt Does São Martinho Carry?

As you can see below, São Martinho had R$4.29b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has R$1.39b in cash leading to net debt of about R$2.90b.

A Look At São Martinho's Liabilities

We can see from the most recent balance sheet that São Martinho had liabilities of R$1.79b falling due within a year, and liabilities of R$6.45b due beyond that. Offsetting these obligations, it had cash of R$1.39b as well as receivables valued at R$385.8m due within 12 months. So its liabilities total R$6.47b more than the combination of its cash and short-term receivables.

São Martinho has a market capitalization of R$12.8b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

São Martinho has net debt worth 1.7 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.4 times the interest expense. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. Shareholders should be aware that São Martinho's EBIT was down 23% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 São Martinho 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, São Martinho recorded free cash flow worth 79% 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

São Martinho's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its conversion of EBIT to free cash flow was re-invigorating. When we consider all the factors discussed, it seems to us that São Martinho is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for São Martinho you should know about.

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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