Is Sinqia (BVMF:SQIA3) A Risky Investment?

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. As with many other companies Sinqia S.A. (BVMF:SQIA3) makes use of debt. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Our analysis indicates that SQIA3 is potentially undervalued!

What Is Sinqia's Debt?

The image below, which you can click on for greater detail, shows that at September 2022 Sinqia had debt of R$255.3m, up from R$176.2m in one year. On the flip side, it has R$184.4m in cash leading to net debt of about R$70.9m.

A Look At Sinqia's Liabilities

Zooming in on the latest balance sheet data, we can see that Sinqia had liabilities of R$250.9m due within 12 months and liabilities of R$474.3m due beyond that. On the other hand, it had cash of R$184.4m and R$64.2m worth of receivables due within a year. So its liabilities total R$476.6m more than the combination of its cash and short-term receivables.

Sinqia has a market capitalization of R$1.24b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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

While Sinqia's low debt to EBITDA ratio of 1.0 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.7 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Pleasingly, Sinqia is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 296% gain in the last twelve months. 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 Sinqia 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.

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. Happily for any shareholders, Sinqia actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

The good news is that Sinqia's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its interest cover. Taking all this data into account, it seems to us that Sinqia takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. Over time, share prices tend to follow earnings per share, so if you're interested in Sinqia, you may well want to click here to check an interactive graph of its earnings per share history.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.