Does Compañía Electro Metalúrgica (SNSE:ELECMETAL) Have A Healthy Balance Sheet?

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 Compañía Electro Metalúrgica S.A. (SNSE:ELECMETAL) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Compañía Electro Metalúrgica

What Is Compañía Electro Metalúrgica's Debt?

As you can see below, at the end of December 2020, Compañía Electro Metalúrgica had CL$440.4b of debt, up from CL$386.1b a year ago. Click the image for more detail. However, it also had CL$111.5b in cash, and so its net debt is CL$328.9b.

A Look At Compañía Electro Metalúrgica's Liabilities

According to the last reported balance sheet, Compañía Electro Metalúrgica had liabilities of CL$197.4b due within 12 months, and liabilities of CL$407.8b due beyond 12 months. On the other hand, it had cash of CL$111.5b and CL$197.9b worth of receivables due within a year. So it has liabilities totalling CL$295.8b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Compañía Electro Metalúrgica is worth CL$525.6b, and thus could probably raise enough capital to shore up 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.

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

Compañía Electro Metalúrgica has a debt to EBITDA ratio of 3.4 and its EBIT covered its interest expense 3.2 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. More concerning, Compañía Electro Metalúrgica saw its EBIT drop by 9.2% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Compañía Electro Metalúrgica will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Compañía Electro Metalúrgica created free cash flow amounting to 9.4% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On the face of it, Compañía Electro Metalúrgica'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. And even its net debt to EBITDA fails to inspire much confidence. Looking at the bigger picture, it seems clear to us that Compañía Electro Metalúrgica's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. To that end, you should learn about the 3 warning signs we've spotted with Compañía Electro Metalúrgica (including 2 which shouldn't be ignored) .

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. 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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