Consorcio ARA S. A. B. de C. V (BMV:ARA) Seems To Use Debt Quite Sensibly

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Consorcio ARA, S. A. B. de C. V. (BMV:ARA) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Consorcio ARA S. A. B. de C. V

What Is Consorcio ARA S. A. B. de C. V's Debt?

The image below, which you can click on for greater detail, shows that Consorcio ARA S. A. B. de C. V had debt of Mex$2.29b at the end of September 2020, a reduction from Mex$2.70b over a year. But on the other hand it also has Mex$2.97b in cash, leading to a Mex$678.5m net cash position.

A Look At Consorcio ARA S. A. B. de C. V's Liabilities

According to the last reported balance sheet, Consorcio ARA S. A. B. de C. V had liabilities of Mex$2.54b due within 12 months, and liabilities of Mex$4.45b due beyond 12 months. On the other hand, it had cash of Mex$2.97b and Mex$921.8m worth of receivables due within a year. So its liabilities total Mex$3.10b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of Mex$4.50b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Despite its noteworthy liabilities, Consorcio ARA S. A. B. de C. V boasts net cash, so it's fair to say it does not have a heavy debt load!

It is just as well that Consorcio ARA S. A. B. de C. V's load is not too heavy, because its EBIT was down 53% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Consorcio ARA S. A. B. de C. V 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. Consorcio ARA S. A. B. de C. V may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Happily for any shareholders, Consorcio ARA S. A. B. de C. V actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

While Consorcio ARA S. A. B. de C. V does have more liabilities than liquid assets, it also has net cash of Mex$678.5m. The cherry on top was that in converted 120% of that EBIT to free cash flow, bringing in Mex$947m. So we don't have any problem with Consorcio ARA S. A. B. de C. V's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Consorcio ARA S. A. B. de C. V is showing 1 warning sign in our investment analysis , 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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