Here's Why Plaza (SNSE:MALLPLAZA) Can Manage Its Debt Responsibly

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.' 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. As with many other companies Plaza S.A. (SNSE:MALLPLAZA) makes use of debt. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Plaza

What Is Plaza's Net Debt?

As you can see below, at the end of June 2023, Plaza had CL$1.25t of debt, up from CL$1.16t a year ago. Click the image for more detail. However, it does have CL$133.6b in cash offsetting this, leading to net debt of about CL$1.12t.

A Look At Plaza's Liabilities

According to the last reported balance sheet, Plaza had liabilities of CL$110.4b due within 12 months, and liabilities of CL$1.91t due beyond 12 months. On the other hand, it had cash of CL$133.6b and CL$136.9b worth of receivables due within a year. So its liabilities total CL$1.75t more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CL$2.35t. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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).

Plaza has a debt to EBITDA ratio of 4.2, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 12.7 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Plaza grew its EBIT by 5.8% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Plaza 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, Plaza actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Both Plaza's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. Having said that, its net debt to EBITDA somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the elements mentioned above, it seems to us that Plaza is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. Case in point: We've spotted 3 warning signs for Plaza 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.