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 BR Properties S.A. (BVMF:BRPR3) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 think about a company's use of debt, we first look at cash and debt together.
What Is BR Properties's Net Debt?
The image below, which you can click on for greater detail, shows that at December 2020 BR Properties had debt of R$2.27b, up from R$1.80b in one year. However, it also had R$1.09b in cash, and so its net debt is R$1.18b.
How Strong Is BR Properties' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that BR Properties had liabilities of R$393.4m due within 12 months and liabilities of R$2.98b due beyond that. Offsetting these obligations, it had cash of R$1.09b as well as receivables valued at R$58.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$2.23b.
This deficit isn't so bad because BR Properties is worth R$3.93b, and thus could probably raise enough capital to shore up 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.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
BR Properties has a rather high debt to EBITDA ratio of 5.4 which suggests a meaningful debt load. However, its interest coverage of 4.0 is reasonably strong, which is a good sign. On the other hand, BR Properties grew its EBIT by 22% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine BR Properties'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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, BR Properties actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
When it comes to the balance sheet, the standout positive for BR Properties was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. In particular, net debt to EBITDA gives us cold feet. When we consider all the elements mentioned above, it seems to us that BR Properties is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that BR Properties is showing 3 warning signs in our investment analysis , you should know about...
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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