São Carlos Empreendimentos e Participações (BVMF:SCAR3) Seems To Use Debt Quite Sensibly

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. As with many other companies São Carlos Empreendimentos e Participações S.A. (BVMF:SCAR3) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for São Carlos Empreendimentos e Participações

How Much Debt Does São Carlos Empreendimentos e Participações Carry?

As you can see below, at the end of September 2020, São Carlos Empreendimentos e Participações had R$1.56b of debt, up from R$1.23b a year ago. Click the image for more detail. However, it does have R$540.9m in cash offsetting this, leading to net debt of about R$1.02b.

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$307.2m due within 12 months, and liabilities of R$1.33b due beyond 12 months. Offsetting these obligations, it had cash of R$540.9m as well as receivables valued at R$72.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$1.02b.

This deficit isn't so bad because São Carlos Empreendimentos e Participações is worth R$2.37b, 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.

São Carlos Empreendimentos e Participações has a debt to EBITDA ratio of 3.2 and its EBIT covered its interest expense 3.8 times. 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 111%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. When analysing debt levels, the balance sheet is the obvious place to start. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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 18% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On our analysis São Carlos Empreendimentos e Participações's EBIT growth rate should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. Looking at all this data makes us feel a little cautious about São Carlos Empreendimentos e Participações's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There's no doubt that we learn most about debt from the balance sheet. 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 makes us a bit uncomfortable!) that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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