Stock Analysis

These 4 Measures Indicate That Embpar Participacoes (BVMF:EPAR3) Is Using Debt Reasonably Well

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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. Importantly, Embpar Participacoes S.A. (BVMF:EPAR3) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

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How Much Debt Does Embpar Participacoes Carry?

As you can see below, at the end of December 2022, Embpar Participacoes had R$79.3m of debt, up from R$55.5m a year ago. Click the image for more detail. However, it does have R$33.5m in cash offsetting this, leading to net debt of about R$45.8m.

BOVESPA:EPAR3 Debt to Equity History March 16th 2023

How Healthy Is Embpar Participacoes' Balance Sheet?

The latest balance sheet data shows that Embpar Participacoes had liabilities of R$157.0m due within a year, and liabilities of R$43.8m falling due after that. Offsetting these obligations, it had cash of R$33.5m as well as receivables valued at R$125.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$41.4m.

While this might seem like a lot, it is not so bad since Embpar Participacoes has a market capitalization of R$157.5m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Embpar Participacoes has a low net debt to EBITDA ratio of only 0.49. And its EBIT easily covers its interest expense, being 11.2 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Another good sign is that Embpar Participacoes has been able to increase its EBIT by 24% in twelve months, making it easier to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Embpar Participacoes will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Embpar Participacoes saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Embpar Participacoes's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. Considering this range of data points, we think Embpar Participacoes is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. We've identified 3 warning signs with Embpar Participacoes (at least 1 which is potentially serious) , and understanding them should be part of your investment process.

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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