Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We can see that Alfa, S.A.B. de C.V. (BMV:ALFAA) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.
View our latest analysis for Alfa. de
What Is Alfa. de's Debt?
The chart below, which you can click on for greater detail, shows that Alfa. de had Mex$117.2b in debt in March 2022; about the same as the year before. On the flip side, it has Mex$25.8b in cash leading to net debt of about Mex$91.4b.
How Healthy Is Alfa. de's Balance Sheet?
The latest balance sheet data shows that Alfa. de had liabilities of Mex$82.4b due within a year, and liabilities of Mex$127.9b falling due after that. Offsetting these obligations, it had cash of Mex$25.8b as well as receivables valued at Mex$39.9b due within 12 months. So it has liabilities totalling Mex$144.6b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the Mex$67.0b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Alfa. de would likely require a major re-capitalisation if it had to pay its creditors today.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).
Alfa. de's net debt is sitting at a very reasonable 2.2 times its EBITDA, while its EBIT covered its interest expense just 5.2 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. It is well worth noting that Alfa. de's EBIT shot up like bamboo after rain, gaining 49% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Alfa. de 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Alfa. de generated free cash flow amounting to a very robust 94% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Our View
We feel some trepidation about Alfa. de's difficulty level of total liabilities, but we've got positives to focus on, too. For example, its conversion of EBIT to free cash flow and EBIT growth rate give us some confidence in its ability to manage its debt. We think that Alfa. de's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Alfa. de you should know about.
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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
About BMV:ALFA A
Alfa. de
Engages in the petrochemical and synthetic fiber and refrigerated food businesses in Mexico.
Very undervalued with moderate growth potential.
