Here's Why Prosegur Compañía de Seguridad (BME:PSG) Can Manage Its Debt Responsibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Prosegur Compañía de Seguridad, S.A. (BME:PSG) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Prosegur Compañía de Seguridad

What Is Prosegur Compañía de Seguridad's Debt?

As you can see below, at the end of September 2020, Prosegur Compañía de Seguridad had €2.19b of debt, up from €1.66b a year ago. Click the image for more detail. However, it also had €1.18b in cash, and so its net debt is €1.02b.

How Strong Is Prosegur Compañía de Seguridad's Balance Sheet?

The latest balance sheet data shows that Prosegur Compañía de Seguridad had liabilities of €1.21b due within a year, and liabilities of €2.28b falling due after that. Offsetting this, it had €1.18b in cash and €846.0m in receivables that were due within 12 months. So it has liabilities totalling €1.47b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of €1.21b, we think shareholders really should watch Prosegur Compañía de Seguridad'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.

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.

Prosegur Compañía de Seguridad has a low net debt to EBITDA ratio of only 1.2. And its EBIT covers its interest expense a whopping 19.7 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that Prosegur Compañía de Seguridad grew its EBIT by 112% over twelve months. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Prosegur Compañía de Seguridad can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Prosegur Compañía de Seguridad recorded free cash flow of 33% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Both Prosegur Compañía de Seguridad's ability to to cover its interest expense with its EBIT and its EBIT growth rate gave us comfort that it can handle its debt. But truth be told its level of total liabilities had us nibbling our nails. Looking at all this data makes us feel a little cautious about Prosegur Compañía de Seguridad's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. Be aware that Prosegur Compañía de Seguridad is showing 1 warning sign in our investment analysis , you should know about...

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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