We Think Grupo Gigante S. A. B. de C. V (BMV:GIGANTE) Is Taking Some Risk With Its Debt

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 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 A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

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

What Is Grupo Gigante S. A. B. de C. V's Debt?

The chart below, which you can click on for greater detail, shows that Grupo Gigante S. A. B. de C. V had Mex$11.2b in debt in June 2021; about the same as the year before. On the flip side, it has Mex$3.31b in cash leading to net debt of about Mex$7.85b.

How Healthy Is Grupo Gigante S. A. B. de C. V's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Grupo Gigante S. A. B. de C. V had liabilities of Mex$11.7b due within 12 months and liabilities of Mex$13.3b due beyond that. Offsetting this, it had Mex$3.31b in cash and Mex$2.91b in receivables that were due within 12 months. So it has liabilities totalling Mex$18.8b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of Mex$26.6b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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

While Grupo Gigante S. A. B. de C. V's debt to EBITDA ratio (3.7) suggests that it uses some debt, its interest cover is very weak, at 0.68, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even worse, Grupo Gigante S. A. B. de C. V saw its EBIT tank 27% 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. There's no doubt that we learn most about debt from the balance sheet. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Grupo Gigante S. A. B. de C. V actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

To be frank both Grupo Gigante S. A. B. de C. V's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Grupo Gigante S. A. B. de C. V stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Be aware that Grupo Gigante S. A. B. de C. V is showing 4 warning signs in our investment analysis , and 2 of those are a bit unpleasant...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.