Magazine Luiza (BVMF:MGLU3) Seems To Be Using A Lot Of Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 note that Magazine Luiza S.A. (BVMF:MGLU3) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.

View our latest analysis for Magazine Luiza

What Is Magazine Luiza's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2022 Magazine Luiza had debt of R$6.91b, up from R$1.67b in one year. However, it does have R$1.99b in cash offsetting this, leading to net debt of about R$4.92b.

How Healthy Is Magazine Luiza's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Magazine Luiza had liabilities of R$10.9b due within 12 months and liabilities of R$11.8b due beyond that. Offsetting this, it had R$1.99b in cash and R$9.26b in receivables that were due within 12 months. So its liabilities total R$11.4b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of R$17.2b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Magazine Luiza shareholders face the double whammy of a high net debt to EBITDA ratio (16.5), and fairly weak interest coverage, since EBIT is just 0.076 times the interest expense. The debt burden here is substantial. Even worse, Magazine Luiza saw its EBIT tank 95% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Magazine Luiza's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into 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

On the face of it, Magazine Luiza's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its net debt to EBITDA also fails to instill confidence. Taking into account all the aforementioned factors, it looks like Magazine Luiza has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. We've identified 4 warning signs with Magazine Luiza (at least 3 which are a bit unpleasant) , and understanding them should be part of your investment process.

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.