We Think Jereissati Participações (BVMF:JPSA3) Is Taking Some Risk With Its Debt

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.' 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. Importantly, Jereissati Participações S.A. (BVMF:JPSA3) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Jereissati Participações

What Is Jereissati Participações's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2021 Jereissati Participações had debt of R$3.49b, up from R$2.62b in one year. However, it also had R$1.54b in cash, and so its net debt is R$1.95b.

How Healthy Is Jereissati Participações' Balance Sheet?

The latest balance sheet data shows that Jereissati Participações had liabilities of R$759.0m due within a year, and liabilities of R$3.01b falling due after that. Offsetting these obligations, it had cash of R$1.54b as well as receivables valued at R$209.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$2.02b.

This is a mountain of leverage relative to its market capitalization of R$3.02b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Jereissati Participações has a debt to EBITDA ratio of 4.3 and its EBIT covered its interest expense 5.5 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Unfortunately, Jereissati Participações's EBIT flopped 14% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. There's no doubt that we learn most about debt from the balance sheet. But it is Jereissati Participações's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Considering the last three years, Jereissati Participações actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

To be frank both Jereissati Participações's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. We're quite clear that we consider Jereissati Participações to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For instance, we've identified 2 warning signs for Jereissati Participações (1 is significant) you should be aware of.

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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