Magazine Luiza (BVMF:MGLU3) Takes On Some Risk With Its Use Of Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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, Magazine Luiza S.A. (BVMF:MGLU3) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider 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 2023 Magazine Luiza had debt of R$7.27b, up from R$6.91b in one year. On the flip side, it has R$2.23b in cash leading to net debt of about R$5.04b.

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$12.8b due within 12 months and liabilities of R$11.1b due beyond that. Offsetting these obligations, it had cash of R$2.23b as well as receivables valued at R$8.02b due within 12 months. So its liabilities total R$13.7b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of R$20.4b, so it does suggest shareholders should keep an eye on Magazine Luiza's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

While we wouldn't worry about Magazine Luiza's net debt to EBITDA ratio of 4.1, we think its super-low interest cover of 0.82 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. However, it should be some comfort for shareholders to recall that Magazine Luiza actually grew its EBIT by a hefty 678%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Magazine Luiza 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Magazine Luiza saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Magazine Luiza's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Magazine Luiza's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Magazine Luiza you should be aware of, and 1 of them is a bit unpleasant.

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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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.