Paz (SNSE:PAZ) Has A Somewhat Strained Balance Sheet

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies Paz Corp S.A. (SNSE:PAZ) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Paz

What Is Paz's Net Debt?

As you can see below, Paz had CL$331.1b of debt, at March 2022, which is about the same as the year before. You can click the chart for greater detail. However, it does have CL$25.4b in cash offsetting this, leading to net debt of about CL$305.7b.

How Healthy Is Paz's Balance Sheet?

We can see from the most recent balance sheet that Paz had liabilities of CL$209.8b falling due within a year, and liabilities of CL$223.3b due beyond that. On the other hand, it had cash of CL$25.4b and CL$25.9b worth of receivables due within a year. So it has liabilities totalling CL$381.8b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CL$89.9b 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, Paz would probably need a major re-capitalization if its creditors were to demand repayment.

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.

As it happens Paz has a fairly concerning net debt to EBITDA ratio of 9.0 but very strong interest coverage of 106. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Pleasingly, Paz is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 130% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Paz 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Paz saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Paz's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, it seems to us that Paz's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for Paz you should be aware of, and 2 of them shouldn't be ignored.

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.