Irani Papel e Embalagem (BVMF:RANI3) Seems To Use Debt Quite Sensibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Irani Papel e Embalagem S.A. (BVMF:RANI3) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Irani Papel e Embalagem

What Is Irani Papel e Embalagem's Net Debt?

The image below, which you can click on for greater detail, shows that Irani Papel e Embalagem had debt of R$638.0m at the end of September 2020, a reduction from R$850.2m over a year. On the flip side, it has R$377.4m in cash leading to net debt of about R$260.6m.

A Look At Irani Papel e Embalagem's Liabilities

The latest balance sheet data shows that Irani Papel e Embalagem had liabilities of R$281.1m due within a year, and liabilities of R$774.8m falling due after that. Offsetting these obligations, it had cash of R$377.4m as well as receivables valued at R$252.3m due within 12 months. So its liabilities total R$426.3m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Irani Papel e Embalagem has a market capitalization of R$1.58b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Irani Papel e Embalagem has a very low debt to EBITDA ratio of 1.1 so it is strange to see weak interest coverage, with last year's EBIT being only 1.9 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. One way Irani Papel e Embalagem could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 14%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Irani Papel e Embalagem 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Irani Papel e Embalagem produced sturdy free cash flow equating to 56% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Based on what we've seen Irani Papel e Embalagem is not finding it easy, given its interest cover, but the other factors we considered give us cause to be optimistic. There's no doubt that it has an adequate capacity handle its debt, based on its EBITDA,. When we consider all the elements mentioned above, it seems to us that Irani Papel e Embalagem is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. We've identified 4 warning signs with Irani Papel e Embalagem (at least 2 which are significant) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. 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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