São Carlos Empreendimentos e Participações (BVMF:SCAR3) Takes On Some Risk With Its Use Of Debt

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.' 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. As with many other companies São Carlos Empreendimentos e Participações S.A. (BVMF:SCAR3) makes use of debt. But should shareholders be worried about its use of debt?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for São Carlos Empreendimentos e Participações

What Is São Carlos Empreendimentos e Participações's Debt?

You can click the graphic below for the historical numbers, but it shows that São Carlos Empreendimentos e Participações had R$1.56b of debt in December 2023, down from R$1.95b, one year before. However, it does have R$126.7m in cash offsetting this, leading to net debt of about R$1.43b.

A Look At São Carlos Empreendimentos e Participações' Liabilities

The latest balance sheet data shows that São Carlos Empreendimentos e Participações had liabilities of R$376.8m due within a year, and liabilities of R$1.46b falling due after that. On the other hand, it had cash of R$126.7m and R$283.4m worth of receivables due within a year. So its liabilities total R$1.42b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of R$1.58b, so it does suggest shareholders should keep an eye on São Carlos Empreendimentos e Participações' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Even though São Carlos Empreendimentos e Participações's debt is only 2.4, its interest cover is really very low at 2.1. This does suggest the company is paying fairly high interest rates. Either way there's no doubt the stock is using meaningful leverage. Pleasingly, São Carlos Empreendimentos e Participações is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 288% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, São Carlos Empreendimentos e Participações reported free cash flow worth 6.5% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

São Carlos Empreendimentos e Participações's interest cover and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that São Carlos Empreendimentos e Participações is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For example, we've discovered 2 warning signs for São Carlos Empreendimentos e Participações that you should be aware of before investing here.

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.