Here's Why Localiza Rent a Car (BVMF:RENT3) Has A Meaningful Debt Burden

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Localiza Rent a Car S.A. (BVMF:RENT3) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Localiza Rent a Car

What Is Localiza Rent a Car's Net Debt?

As you can see below, at the end of December 2023, Localiza Rent a Car had R$41.2b of debt, up from R$33.7b a year ago. Click the image for more detail. However, because it has a cash reserve of R$10.3b, its net debt is less, at about R$30.9b.

How Healthy Is Localiza Rent a Car's Balance Sheet?

According to the last reported balance sheet, Localiza Rent a Car had liabilities of R$18.4b due within 12 months, and liabilities of R$37.1b due beyond 12 months. Offsetting this, it had R$10.3b in cash and R$4.60b in receivables that were due within 12 months. So it has liabilities totalling R$40.6b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its very significant market capitalization of R$52.5b, so it does suggest shareholders should keep an eye on Localiza Rent a Car'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 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Localiza Rent a Car shareholders face the double whammy of a high net debt to EBITDA ratio (5.0), and fairly weak interest coverage, since EBIT is just 1.5 times the interest expense. The debt burden here is substantial. Looking on the bright side, Localiza Rent a Car boosted its EBIT by a silky 34% in the last year. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Localiza Rent a Car 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Localiza Rent a Car 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

On the face of it, Localiza Rent a Car'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 at least it's pretty decent at growing its EBIT; that's encouraging. Overall, we think it's fair to say that Localiza Rent a Car has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. For example, we've discovered 5 warning signs for Localiza Rent a Car (2 are a bit unpleasant!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.