Here's Why Grupo Traxión. de (BMV:TRAXIONA) Has A Meaningful Debt Burden

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.' 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 Traxión, S.A.B. de C.V. (BMV:TRAXIONA) does use debt in its business. But the real question is whether this debt is making the company risky.

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Our analysis indicates that TRAXION A is potentially undervalued!

How Much Debt Does Grupo Traxión. de Carry?

As you can see below, at the end of June 2022, Grupo Traxión. de had Mex$7.05b of debt, up from Mex$5.99b a year ago. Click the image for more detail. However, it does have Mex$848.1m in cash offsetting this, leading to net debt of about Mex$6.20b.

A Look At Grupo Traxión. de's Liabilities

We can see from the most recent balance sheet that Grupo Traxión. de had liabilities of Mex$4.93b falling due within a year, and liabilities of Mex$7.51b due beyond that. Offsetting these obligations, it had cash of Mex$848.1m as well as receivables valued at Mex$4.49b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by Mex$7.10b.

This is a mountain of leverage relative to its market capitalization of Mex$9.50b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Grupo Traxión. de's net debt is sitting at a very reasonable 2.1 times its EBITDA, while its EBIT covered its interest expense just 2.8 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 Traxión. de saw its EBIT slide 8.2% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Grupo Traxión. de's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Grupo Traxión. de recorded free cash flow worth 60% 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

While Grupo Traxión. de's EBIT growth rate makes us cautious about it, its track record of covering its interest expense with its EBIT is no better. At least its conversion of EBIT to free cash flow gives us reason to be optimistic. When we consider all the factors discussed, it seems to us that Grupo Traxión. de is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Grupo Traxión. de , and understanding them should be part of your investment process.

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.

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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.