We Think São Martinho (BVMF:SMTO3) Can Stay On Top Of Its Debt

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 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. Importantly, São Martinho S.A. (BVMF:SMTO3) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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. 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for São Martinho

What Is São Martinho's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2021 São Martinho had R$5.01b of debt, an increase on R$4.29b, over one year. However, because it has a cash reserve of R$1.51b, its net debt is less, at about R$3.50b.

A Look At São Martinho's Liabilities

The latest balance sheet data shows that São Martinho had liabilities of R$2.10b due within a year, and liabilities of R$7.46b falling due after that. On the other hand, it had cash of R$1.51b and R$456.4m worth of receivables due within a year. So its liabilities total R$7.59b more than the combination of its cash and short-term receivables.

São Martinho has a market capitalization of R$16.3b, 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.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

São Martinho's net debt is only 1.2 times its EBITDA. And its EBIT easily covers its interest expense, being 10.4 times the size. So we're pretty relaxed about its super-conservative use of debt. But the other side of the story is that São Martinho saw its EBIT decline by 3.4% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine São Martinho's ability to maintain a healthy balance sheet going forward. 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, São Martinho recorded free cash flow worth 66% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

São Martinho's interest cover was a real positive on this analysis, as was its conversion of EBIT to free cash flow. On the other hand, its EBIT growth rate makes us a little less comfortable about its debt. When we consider all the elements mentioned above, it seems to us that São Martinho is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. To that end, you should learn about the 5 warning signs we've spotted with São Martinho (including 1 which is concerning) .

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.