São Carlos Empreendimentos e Participações (BVMF:SCAR3) Seems To Be Using A Lot Of 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 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 note that São Carlos Empreendimentos e Participações S.A. (BVMF:SCAR3) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for São Carlos Empreendimentos e Participações

How Much Debt Does São Carlos Empreendimentos e Participações Carry?

As you can see below, São Carlos Empreendimentos e Participações had R$1.83b of debt at September 2023, down from R$2.12b a year prior. However, it does have R$169.3m in cash offsetting this, leading to net debt of about R$1.66b.

How Strong Is São Carlos Empreendimentos e Participações' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that São Carlos Empreendimentos e Participações had liabilities of R$263.8m due within 12 months and liabilities of R$1.70b due beyond that. Offsetting this, it had R$169.3m in cash and R$174.5m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$1.62b.

Given this deficit is actually higher than the company's market capitalization of R$1.40b, we think shareholders really should watch São Carlos Empreendimentos e Participações's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

Weak interest cover of 0.61 times and a disturbingly high net debt to EBITDA ratio of 9.5 hit our confidence in São Carlos Empreendimentos e Participações like a one-two punch to the gut. The debt burden here is substantial. More concerning, São Carlos Empreendimentos e Participações saw its EBIT drop by 6.3% in the last twelve months. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. 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 Carlos Empreendimentos e Participações'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, São Carlos Empreendimentos e Participações created free cash flow amounting to 14% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On the face of it, São Carlos Empreendimentos e Participações's net debt to EBITDA left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its conversion of EBIT to free cash flow also fails to instill confidence. Taking into account all the aforementioned factors, it looks like São Carlos Empreendimentos e Participações has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. To that end, you should learn about the 2 warning signs we've spotted with São Carlos Empreendimentos e Participações (including 1 which is concerning) .

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. 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.