Here's Why Ferrocarril del Pacífico (SNSE:FEPASA) Has A Meaningful Debt Burden

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Ferrocarril del Pacífico S.A. (SNSE:FEPASA) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Ferrocarril del Pacífico

What Is Ferrocarril del Pacífico's Net Debt?

As you can see below, at the end of September 2020, Ferrocarril del Pacífico had CL$26.4b of debt, up from CL$16.6b a year ago. Click the image for more detail. On the flip side, it has CL$7.46b in cash leading to net debt of about CL$18.9b.

How Healthy Is Ferrocarril del Pacífico's Balance Sheet?

The latest balance sheet data shows that Ferrocarril del Pacífico had liabilities of CL$19.0b due within a year, and liabilities of CL$21.3b falling due after that. Offsetting these obligations, it had cash of CL$7.46b as well as receivables valued at CL$16.1b due within 12 months. So its liabilities total CL$16.7b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CL$27.3b, so it does suggest shareholders should keep an eye on Ferrocarril del Pacífico's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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 Ferrocarril del Pacífico's debt to EBITDA ratio (3.2) suggests that it uses some debt, its interest cover is very weak, at 1.8, suggesting 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. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Worse, Ferrocarril del Pacífico's EBIT was down 73% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Ferrocarril del Pacífico's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Ferrocarril del Pacífico produced sturdy free cash flow equating to 53% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

To be frank both Ferrocarril del Pacífico's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Ferrocarril del Pacífico'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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Ferrocarril del Pacífico that 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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