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

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 should shareholders be worried about its use of debt?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 our latest analysis for São Carlos Empreendimentos e Participações

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

The image below, which you can click on for greater detail, shows that São Carlos Empreendimentos e Participações had debt of R$1.45b at the end of September 2021, a reduction from R$1.56b over a year. However, it also had R$125.9m in cash, and so its net debt is R$1.33b.

A Look At São Carlos Empreendimentos e Participações' Liabilities

We can see from the most recent balance sheet that São Carlos Empreendimentos e Participações had liabilities of R$193.7m falling due within a year, and liabilities of R$1.33b due beyond that. Offsetting these obligations, it had cash of R$125.9m as well as receivables valued at R$47.0m due within 12 months. So its liabilities total R$1.35b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of R$2.06b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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).

Weak interest cover of 1.9 times and a disturbingly high net debt to EBITDA ratio of 7.3 hit our confidence in São Carlos Empreendimentos e Participações like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. More concerning, São Carlos Empreendimentos e Participações saw its EBIT drop by 6.3% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. 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 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. In the last three years, São Carlos Empreendimentos e Participações's free cash flow amounted to 45% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On the face of it, São Carlos Empreendimentos e Participações's interest cover left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. But at least its conversion of EBIT to free cash flow is not so bad. Looking at the bigger picture, it seems clear to us that São Carlos Empreendimentos e Participações's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that São Carlos Empreendimentos e Participações is showing 4 warning signs in our investment analysis , and 2 of those are concerning...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.