N. Varveris-Moda Bagno (ATH:MODA) Use Of Debt Could Be Considered Risky

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. As with many other companies N. Varveris-Moda Bagno S.A. (ATH:MODA) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 N. Varveris-Moda Bagno

How Much Debt Does N. Varveris-Moda Bagno Carry?

The image below, which you can click on for greater detail, shows that N. Varveris-Moda Bagno had debt of €7.39m at the end of December 2020, a reduction from €8.37m over a year. However, it does have €1.83m in cash offsetting this, leading to net debt of about €5.56m.

How Healthy Is N. Varveris-Moda Bagno's Balance Sheet?

We can see from the most recent balance sheet that N. Varveris-Moda Bagno had liabilities of €11.3m falling due within a year, and liabilities of €16.3m due beyond that. Offsetting these obligations, it had cash of €1.83m as well as receivables valued at €2.68m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €23.0m.

This deficit casts a shadow over the €10.4m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, N. Varveris-Moda Bagno would probably need a major re-capitalization if its creditors were to demand repayment.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While N. Varveris-Moda Bagno's debt to EBITDA ratio (2.8) suggests that it uses some debt, its interest cover is very weak, at 1.6, 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. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Even worse, N. Varveris-Moda Bagno saw its EBIT tank 49% 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. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since N. Varveris-Moda Bagno will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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, N. Varveris-Moda Bagno actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

To be frank both N. Varveris-Moda Bagno's EBIT growth rate and its track record of staying on top of its total liabilities 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. Overall, it seems to us that N. Varveris-Moda Bagno's balance sheet is really quite a risk to the business. 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. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for N. Varveris-Moda Bagno (1 doesn't sit too well with us) you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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