We Think Instituto Hermes Pardini (BVMF:PARD3) Can Stay On Top Of Its Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Instituto Hermes Pardini S.A. (BVMF:PARD3) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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.

See our latest analysis for Instituto Hermes Pardini

What Is Instituto Hermes Pardini's Debt?

As you can see below, at the end of September 2020, Instituto Hermes Pardini had R$429.5m of debt, up from R$231.2m a year ago. Click the image for more detail. However, it does have R$264.6m in cash offsetting this, leading to net debt of about R$164.9m.

How Strong Is Instituto Hermes Pardini's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Instituto Hermes Pardini had liabilities of R$522.9m due within 12 months and liabilities of R$716.0m due beyond that. Offsetting these obligations, it had cash of R$264.6m as well as receivables valued at R$391.6m due within 12 months. So its liabilities total R$582.7m more than the combination of its cash and short-term receivables.

Of course, Instituto Hermes Pardini has a market capitalization of R$2.95b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). 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).

While Instituto Hermes Pardini's low debt to EBITDA ratio of 0.79 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.6 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. But the bad news is that Instituto Hermes Pardini has seen its EBIT plunge 12% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Instituto Hermes Pardini can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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, Instituto Hermes Pardini recorded free cash flow worth 75% 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

Happily, Instituto Hermes Pardini's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But we must concede we find its EBIT growth rate has the opposite effect. It's also worth noting that Instituto Hermes Pardini is in the Healthcare industry, which is often considered to be quite defensive. All these things considered, it appears that Instituto Hermes Pardini can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Instituto Hermes Pardini , and understanding them should be part of your investment process.

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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