Is Parque Arauco (SNSE:PARAUCO) Using Too Much Debt?

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.' 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. Importantly, Parque Arauco S.A. (SNSE:PARAUCO) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Parque Arauco

What Is Parque Arauco's Net Debt?

As you can see below, at the end of March 2021, Parque Arauco had CL$1.18t of debt, up from CL$1.11t a year ago. Click the image for more detail. However, because it has a cash reserve of CL$416.1b, its net debt is less, at about CL$768.4b.

A Look At Parque Arauco's Liabilities

According to the last reported balance sheet, Parque Arauco had liabilities of CL$91.6b due within 12 months, and liabilities of CL$1.47t due beyond 12 months. On the other hand, it had cash of CL$416.1b and CL$31.2b worth of receivables due within a year. So its liabilities total CL$1.11t more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of CL$923.7b, we think shareholders really should watch Parque Arauco's debt levels, like a parent watching their child ride a bike for the first time. 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.

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.

Parque Arauco shareholders face the double whammy of a high net debt to EBITDA ratio (16.9), and fairly weak interest coverage, since EBIT is just 1.0 times the interest expense. The debt burden here is substantial. Even worse, Parque Arauco saw its EBIT tank 69% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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.

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, Parque Arauco generated free cash flow amounting to a very robust 82% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

To be frank both Parque Arauco's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. We're quite clear that we consider Parque Arauco to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For instance, we've identified 2 warning signs for Parque Arauco (1 is potentially serious) you should be aware of.

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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