Does Grupo Mexicano de Desarrollo (BMV:GMD) Have A Healthy Balance Sheet?

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.' 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. We note that Grupo Mexicano de Desarrollo, S.A.B. (BMV:GMD) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Grupo Mexicano de Desarrollo

What Is Grupo Mexicano de Desarrollo's Net Debt?

As you can see below, Grupo Mexicano de Desarrollo had Mex$2.71b of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has Mex$615.0m in cash leading to net debt of about Mex$2.09b.

How Strong Is Grupo Mexicano de Desarrollo's Balance Sheet?

We can see from the most recent balance sheet that Grupo Mexicano de Desarrollo had liabilities of Mex$1.18b falling due within a year, and liabilities of Mex$3.26b due beyond that. Offsetting this, it had Mex$615.0m in cash and Mex$1.01b in receivables that were due within 12 months. So its liabilities total Mex$2.81b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of Mex$3.02b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Grupo Mexicano de Desarrollo's net debt is sitting at a very reasonable 2.0 times its EBITDA, while its EBIT covered its interest expense just 3.9 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Unfortunately, Grupo Mexicano de Desarrollo's EBIT flopped 10% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Grupo Mexicano de Desarrollo 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Grupo Mexicano de Desarrollo's free cash flow amounted to 38% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Grupo Mexicano de Desarrollo's level of total liabilities and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. Having said that, its ability handle its debt, based on its EBITDA, isn't such a worry. Overall, we think it's fair to say that Grupo Mexicano de Desarrollo has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Grupo Mexicano de Desarrollo , and understanding them should be part of your investment process.

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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