We Think Sonae SGPS (ELI:SON) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Sonae, SGPS, S.A. (ELI:SON) does use debt in its business. But should shareholders be worried about its use of debt?

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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Sonae SGPS

How Much Debt Does Sonae SGPS Carry?

The image below, which you can click on for greater detail, shows that Sonae SGPS had debt of €1.65b at the end of September 2021, a reduction from €1.95b over a year. However, because it has a cash reserve of €774.3m, its net debt is less, at about €877.0m.

How Strong Is Sonae SGPS' Balance Sheet?

The latest balance sheet data shows that Sonae SGPS had liabilities of €2.39b due within a year, and liabilities of €2.77b falling due after that. Offsetting this, it had €774.3m in cash and €416.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €3.97b.

This deficit casts a shadow over the €1.86b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Sonae SGPS would likely require a major re-capitalisation if it had to pay its creditors today.

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

Sonae SGPS has net debt worth 2.3 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 2.6 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. One way Sonae SGPS could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 19%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Sonae SGPS's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Sonae SGPS 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.

Our View

Neither Sonae SGPS's ability to handle its total liabilities nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Taking the abovementioned factors together we do think Sonae SGPS's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. Given Sonae SGPS has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.

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.