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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, CAP S.A. (SNSE:CAP) does carry debt. But should shareholders be worried about its use of debt?
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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is CAP's Net Debt?
The chart below, which you can click on for greater detail, shows that CAP had US$830.7m in debt in June 2022; about the same as the year before. However, because it has a cash reserve of US$306.7m, its net debt is less, at about US$523.9m.
How Healthy Is CAP's Balance Sheet?
We can see from the most recent balance sheet that CAP had liabilities of US$1.29b falling due within a year, and liabilities of US$1.35b due beyond that. Offsetting this, it had US$306.7m in cash and US$371.6m in receivables that were due within 12 months. So it has liabilities totalling US$1.96b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the US$968.8m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, CAP would likely require a major re-capitalisation if it had to pay its creditors today.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).
CAP's net debt is only 0.49 times its EBITDA. 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. It is just as well that CAP's load is not too heavy, because its EBIT was down 50% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if CAP can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, CAP recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
To be frank both CAP's EBIT growth rate 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. Looking at the bigger picture, it seems clear to us that CAP's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 4 warning signs for CAP (1 is concerning) you should be aware of.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.
CAP S.A. engages in iron ore mining, steel production, and steel processing businesses in Chile and internationally.
The Snowflake is a visual investment summary with the score of each axis being calculated by 6 checks in 5 areas.
|Analysis Area||Score (0-6)|
Read more about these checks in the individual report sections or in our analysis model.
Very undervalued with flawless balance sheet.