Quiñenco (SNSE:QUINENCO) Takes On Some Risk With Its Use Of Debt

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.' 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. We note that Quiñenco S.A. (SNSE:QUINENCO) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Our analysis indicates that QUINENCO is potentially undervalued!

How Much Debt Does Quiñenco Carry?

As you can see below, at the end of June 2022, Quiñenco had CL$18t of debt, up from CL$17t a year ago. Click the image for more detail. However, because it has a cash reserve of CL$899.6b, its net debt is less, at about CL$17t.

A Look At Quiñenco's Liabilities

The latest balance sheet data shows that Quiñenco had liabilities of CL$37t due within a year, and liabilities of CL$17t falling due after that. On the other hand, it had cash of CL$899.6b and CL$964.2b worth of receivables due within a year. So its liabilities total CL$53t more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CL$3.77t company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Quiñenco would probably need a major re-capitalization if its creditors were to demand repayment.

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.

As it happens Quiñenco has a fairly concerning net debt to EBITDA ratio of 10.2 but very strong interest coverage of 22.9. So either it has access to very cheap long term debt or that interest expense is going to grow! It is well worth noting that Quiñenco's EBIT shot up like bamboo after rain, gaining 93% in the last twelve months. That'll make it easier to manage 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 Quiñenco will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Happily for any shareholders, Quiñenco 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

While Quiñenco's level of total liabilities has us nervous. For example, its interest cover and conversion of EBIT to free cash flow give us some confidence in its ability to manage its debt. We think that Quiñenco's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Quiñenco (of which 1 is potentially serious!) 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. 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.