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.’ 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 Viña San Pedro Tarapacá S.A. (SNSE:VSPT) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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.
How Much Debt Does Viña San Pedro Tarapacá Carry?
As you can see below, at the end of June 2020, Viña San Pedro Tarapacá had CL$109.4b of debt, up from CL$49.0b a year ago. Click the image for more detail. However, it does have CL$57.4b in cash offsetting this, leading to net debt of about CL$52.0b.
How Strong Is Viña San Pedro Tarapacá’s Balance Sheet?
We can see from the most recent balance sheet that Viña San Pedro Tarapacá had liabilities of CL$110.4b falling due within a year, and liabilities of CL$80.5b due beyond that. Offsetting these obligations, it had cash of CL$57.4b as well as receivables valued at CL$65.1b due within 12 months. So it has liabilities totalling CL$68.5b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Viña San Pedro Tarapacá has a market capitalization of CL$291.8b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Viña San Pedro Tarapacá has a low net debt to EBITDA ratio of only 1.1. And its EBIT easily covers its interest expense, being 24.0 times the size. So we’re pretty relaxed about its super-conservative use of debt. In addition to that, we’re happy to report that Viña San Pedro Tarapacá has boosted its EBIT by 71%, thus reducing the spectre of future debt repayments. There’s no doubt that we learn most about debt from the balance sheet. But it is Viña San Pedro Tarapacá’s earnings that will influence how the balance sheet holds up in the future. 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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. In the last three years, Viña San Pedro Tarapacá created free cash flow amounting to 14% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Happily, Viña San Pedro Tarapacá’s impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. All these things considered, it appears that Viña San Pedro Tarapacá can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. 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. Take risks, for example – Viña San Pedro Tarapacá has 3 warning signs (and 1 which is a bit concerning) we think you should know about.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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