Here's Why São Carlos Empreendimentos e Participações (BVMF:SCAR3) Is Weighed Down By Its Debt Load

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that São Carlos Empreendimentos e Participações S.A. (BVMF:SCAR3) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out the opportunities and risks within the BR Real Estate industry.

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

The image below, which you can click on for greater detail, shows that at June 2022 São Carlos Empreendimentos e Participações had debt of R$1.89b, up from R$1.35b in one year. Net debt is about the same, since the it doesn't have much cash.

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$283.4m due within 12 months and liabilities of R$1.67b due beyond that. On the other hand, it had cash of R$7.48m and R$53.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$1.89b.

Given this deficit is actually higher than the company's market capitalization of R$1.52b, 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. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). 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 shareholders face the double whammy of a high net debt to EBITDA ratio (10.3), and fairly weak interest coverage, since EBIT is just 0.90 times the interest expense. This means we'd consider it to have a heavy debt load. Investors should also be troubled by the fact that São Carlos Empreendimentos e Participações saw its EBIT drop by 17% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. The balance sheet is clearly the area to focus on when you are analysing debt. 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, São Carlos Empreendimentos e Participações's free cash flow amounted to 35% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

To be frank both São Carlos Empreendimentos e Participações's net debt to EBITDA and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. Having said that, its ability to convert EBIT to free cash flow isn't such a worry. After considering the datapoints discussed, we think São Carlos Empreendimentos e Participações has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. Be aware that São Carlos Empreendimentos e Participações is showing 2 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.