Does Parque Arauco (SNSE:PARAUCO) Have A Healthy Balance Sheet?

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 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, Parque Arauco S.A. (SNSE:PARAUCO) does carry debt. But the more important question is: how much risk is that debt creating?

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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Parque Arauco

What Is Parque Arauco's Net Debt?

The image below, which you can click on for greater detail, shows that Parque Arauco had debt of CL$1.10t at the end of September 2021, a reduction from CL$1.33t over a year. However, it also had CL$326.5b in cash, and so its net debt is CL$776.2b.

How Strong Is Parque Arauco's Balance Sheet?

We can see from the most recent balance sheet that Parque Arauco had liabilities of CL$122.7b falling due within a year, and liabilities of CL$1.33t due beyond that. On the other hand, it had cash of CL$326.5b and CL$33.9b worth of receivables due within a year. So its liabilities total CL$1.10t more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's CL$760.8b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 2.2 times and a disturbingly high net debt to EBITDA ratio of 7.7 hit our confidence in Parque Arauco like a one-two punch to the gut. The debt burden here is substantial. The good news is that Parque Arauco grew its EBIT a smooth 51% over the last twelve months. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Parque Arauco's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Parque Arauco recorded free cash flow worth a fulsome 84% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

We feel some trepidation about Parque Arauco's difficulty net debt to EBITDA, but we've got positives to focus on, too. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. When we consider all the factors discussed, it seems to us that Parque Arauco is taking some risks with its use of debt. 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. However, not all investment risk resides within the balance sheet - far from it. Be aware that Parque Arauco is showing 3 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.