Is Esval (SNSE:ESVAL-C) A Risky Investment?

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.' 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. As with many other companies Esval S.A. (SNSE:ESVAL-C) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Esval

How Much Debt Does Esval Carry?

As you can see below, at the end of March 2021, Esval had CL$535.8b of debt, up from CL$514.2b a year ago. Click the image for more detail. However, it does have CL$15.8b in cash offsetting this, leading to net debt of about CL$520.0b.

How Healthy Is Esval's Balance Sheet?

The latest balance sheet data shows that Esval had liabilities of CL$81.3b due within a year, and liabilities of CL$551.3b falling due after that. Offsetting these obligations, it had cash of CL$15.8b as well as receivables valued at CL$56.6b due within 12 months. So it has liabilities totalling CL$560.3b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of CL$389.0b, we think shareholders really should watch Esval's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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.

Weak interest cover of 2.4 times and a disturbingly high net debt to EBITDA ratio of 7.0 hit our confidence in Esval like a one-two punch to the gut. The debt burden here is substantial. Worse, Esval's EBIT was down 26% over the last year. 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. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Esval will need earnings to service that debt. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Esval created free cash flow amounting to 18% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On the face of it, Esval's net debt to EBITDA left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And even its interest cover fails to inspire much confidence. It's also worth noting that Esval is in the Water Utilities industry, which is often considered to be quite defensive. After considering the datapoints discussed, we think Esval has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. We've identified 3 warning signs with Esval (at least 2 which are a bit concerning) , and understanding them should be part of your investment process.

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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