We Think Localiza Rent a Car (BVMF:RENT3) Can Stay On Top Of Its 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. As with many other companies Localiza Rent a Car S.A. (BVMF:RENT3) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Localiza Rent a Car

How Much Debt Does Localiza Rent a Car Carry?

As you can see below, Localiza Rent a Car had R$10.4b of debt at March 2021, down from R$11.2b a year prior. However, it does have R$3.44b in cash offsetting this, leading to net debt of about R$6.99b.

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

Zooming in on the latest balance sheet data, we can see that Localiza Rent a Car had liabilities of R$4.42b due within 12 months and liabilities of R$9.41b due beyond that. On the other hand, it had cash of R$3.44b and R$1.31b worth of receivables due within a year. So its liabilities total R$9.08b more than the combination of its cash and short-term receivables.

Of course, Localiza Rent a Car has a market capitalization of R$48.5b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With net debt to EBITDA of 3.5 Localiza Rent a Car has a fairly noticeable amount of debt. But the high interest coverage of 8.3 suggests it can easily service that debt. Importantly, Localiza Rent a Car grew its EBIT by 34% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Localiza Rent a Car'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 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, Localiza Rent a Car burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Localiza Rent a Car's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its EBIT growth rate. When we consider all the factors mentioned above, we do feel a bit cautious about Localiza Rent a Car's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. Be aware that Localiza Rent a Car is showing 1 warning sign in our investment analysis , you should know about...

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. 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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