Grupo Gigante S. A. B. de C. V (BMV:GIGANTE) Has A Somewhat Strained Balance Sheet

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.' 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 can see that Grupo Gigante, S. A. B. de C. V. (BMV:GIGANTE) does use debt in its business. 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. 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. 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.

View our latest analysis for Grupo Gigante S. A. B. de C. V

How Much Debt Does Grupo Gigante S. A. B. de C. V Carry?

The image below, which you can click on for greater detail, shows that at September 2020 Grupo Gigante S. A. B. de C. V had debt of Mex$12.4b, up from Mex$10.8b in one year. However, it also had Mex$2.01b in cash, and so its net debt is Mex$10.4b.

A Look At Grupo Gigante S. A. B. de C. V's Liabilities

Zooming in on the latest balance sheet data, we can see that Grupo Gigante S. A. B. de C. V had liabilities of Mex$8.17b due within 12 months and liabilities of Mex$17.6b due beyond that. Offsetting this, it had Mex$2.01b in cash and Mex$2.85b in receivables that were due within 12 months. So its liabilities total Mex$20.9b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of Mex$25.5b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Grupo Gigante S. A. B. de C. V shareholders face the double whammy of a high net debt to EBITDA ratio (6.9), and fairly weak interest coverage, since EBIT is just 0.40 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Grupo Gigante S. A. B. de C. V's EBIT was down 74% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Grupo Gigante S. A. B. de C. V's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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 most recent three years, Grupo Gigante S. A. B. de C. V recorded free cash flow worth 79% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

On the face of it, Grupo Gigante S. A. B. de C. V's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Grupo Gigante S. A. B. de C. V's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Grupo Gigante S. A. B. de C. V that 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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This article by Simply Wall St is general in nature. 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.
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