Is Magazine Luiza (BVMF:MGLU3) A Risky Investment?

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.' 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 Magazine Luiza S.A. (BVMF:MGLU3) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, debt can be an important tool in businesses, particularly capital heavy businesses. 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 Magazine Luiza

What Is Magazine Luiza's Debt?

As you can see below, at the end of June 2021, Magazine Luiza had R$2.33b of debt, up from R$1.66b a year ago. Click the image for more detail. On the flip side, it has R$1.76b in cash leading to net debt of about R$575.1m.

A Look At Magazine Luiza's Liabilities

According to the last reported balance sheet, Magazine Luiza had liabilities of R$11.4b due within 12 months, and liabilities of R$6.39b due beyond 12 months. Offsetting this, it had R$1.76b in cash and R$6.50b in receivables that were due within 12 months. So its liabilities total R$9.54b more than the combination of its cash and short-term receivables.

Of course, Magazine Luiza has a titanic market capitalization of R$99.2b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. But either way, Magazine Luiza has virtually no net debt, so it's fair to say it does not have a heavy debt load!

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

Looking at its net debt to EBITDA of 0.46 and interest cover of 5.1 times, it seems to us that Magazine Luiza is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. It is well worth noting that Magazine Luiza's EBIT shot up like bamboo after rain, gaining 68% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Magazine Luiza 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Magazine Luiza burned a lot of cash. 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

Based on what we've seen Magazine Luiza is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to grow its EBIT is pretty flash. When we consider all the elements mentioned above, it seems to us that Magazine Luiza is managing its debt quite well. 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. For example, we've discovered 3 warning signs for Magazine Luiza 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.

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.

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