These 4 Measures Indicate That São Carlos Empreendimentos e Participações (BVMF:SCAR3) Is Using Debt Extensively

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 São Carlos Empreendimentos e Participações S.A. (BVMF:SCAR3) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 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. 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.

View our latest analysis for São Carlos Empreendimentos e Participações

What Is São Carlos Empreendimentos e Participações's Net Debt?

As you can see below, São Carlos Empreendimentos e Participações had R$1.83b of debt, at June 2023, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of R$109.0m, its net debt is less, at about R$1.72b.

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

According to the last reported balance sheet, São Carlos Empreendimentos e Participações had liabilities of R$247.3m due within 12 months, and liabilities of R$1.74b due beyond 12 months. Offsetting these obligations, it had cash of R$109.0m as well as receivables valued at R$216.2m due within 12 months. So its liabilities total R$1.66b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's R$1.44b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). 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).

São Carlos Empreendimentos e Participações's debt is 2.9 times its EBITDA, and its EBIT cover its interest expense 2.7 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. However, it should be some comfort for shareholders to recall that São Carlos Empreendimentos e Participações actually grew its EBIT by a hefty 311%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if São Carlos Empreendimentos e Participações 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, São Carlos Empreendimentos e Participações created free cash flow amounting to 6.9% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

To be frank both São Carlos Empreendimentos e Participações's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that São Carlos Empreendimentos e Participações's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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 (1 is potentially serious!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.