SalfaCorp (SNSE:SALFACORP) Seems To Be Using A Lot Of Debt

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. We can see that SalfaCorp S.A. (SNSE:SALFACORP) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. 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 SalfaCorp

What Is SalfaCorp's Net Debt?

As you can see below, SalfaCorp had CL$417.7b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CL$70.5b in cash leading to net debt of about CL$347.2b.

A Look At SalfaCorp's Liabilities

According to the last reported balance sheet, SalfaCorp had liabilities of CL$366.6b due within 12 months, and liabilities of CL$322.8b due beyond 12 months. Offsetting these obligations, it had cash of CL$70.5b as well as receivables valued at CL$168.5b due within 12 months. So it has liabilities totalling CL$450.4b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CL$259.2b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, SalfaCorp 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.

SalfaCorp shareholders face the double whammy of a high net debt to EBITDA ratio (18.2), and fairly weak interest coverage, since EBIT is just 1.4 times the interest expense. The debt burden here is substantial. Even worse, SalfaCorp saw its EBIT tank 56% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is SalfaCorp's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Over the last three years, SalfaCorp actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

On the face of it, SalfaCorp's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. We're quite clear that we consider SalfaCorp to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example, we've discovered 4 warning signs for SalfaCorp (2 are a bit unpleasant!) that you should be aware of before investing here.

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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