David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Natura &Co Holding S.A. (BVMF:NTCO3) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Natura &Co Holding Carry?
The image below, which you can click on for greater detail, shows that Natura &Co Holding had debt of R$14.1b at the end of June 2021, a reduction from R$20.7b over a year. However, it does have R$7.99b in cash offsetting this, leading to net debt of about R$6.15b.
A Look At Natura &Co Holding's Liabilities
Zooming in on the latest balance sheet data, we can see that Natura &Co Holding had liabilities of R$14.5b due within 12 months and liabilities of R$17.8b due beyond that. On the other hand, it had cash of R$7.99b and R$5.16b worth of receivables due within a year. So its liabilities total R$19.1b more than the combination of its cash and short-term receivables.
Natura &Co Holding has a very large market capitalization of R$73.0b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Natura &Co Holding has a quite reasonable net debt to EBITDA multiple of 2.1, its interest cover seems weak, at 1.9. This does suggest the company is paying fairly high interest rates. Either way there's no doubt the stock is using meaningful leverage. Notably, Natura &Co Holding's EBIT launched higher than Elon Musk, gaining a whopping 171% on last year. 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 Natura &Co Holding 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 it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Natura &Co Holding actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Natura &Co Holding's interest cover and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. We think that Natura &Co Holding's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Natura &Co Holding (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.
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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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.
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