Compañía Chilena de Fósforos (SNSE:FOSFOROS) Takes On Some Risk With Its Use Of Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 note that Compañía Chilena de Fósforos S.A. (SNSE:FOSFOROS) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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

See our latest analysis for Compañía Chilena de Fósforos

What Is Compañía Chilena de Fósforos's Net Debt?

As you can see below, at the end of December 2022, Compañía Chilena de Fósforos had CL$22.4b of debt, up from CL$10.9b a year ago. Click the image for more detail. On the flip side, it has CL$2.98b in cash leading to net debt of about CL$19.4b.

How Healthy Is Compañía Chilena de Fósforos' Balance Sheet?

According to the last reported balance sheet, Compañía Chilena de Fósforos had liabilities of CL$22.4b due within 12 months, and liabilities of CL$12.5b due beyond 12 months. Offsetting these obligations, it had cash of CL$2.98b as well as receivables valued at CL$13.4b due within 12 months. So it has liabilities totalling CL$18.6b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Compañía Chilena de Fósforos has a market capitalization of CL$49.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While we wouldn't worry about Compañía Chilena de Fósforos's net debt to EBITDA ratio of 3.7, we think its super-low interest cover of 1.9 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Looking on the bright side, Compañía Chilena de Fósforos boosted its EBIT by a silky 49% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. 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 Compañía Chilena de Fósforos 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Compañía Chilena de Fósforos burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Compañía Chilena de Fósforos's conversion of EBIT to free cash flow and interest cover definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Compañía Chilena de Fósforos's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 4 warning signs with Compañía Chilena de Fósforos (at least 2 which make us uncomfortable) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.