Here's Why Semapa - Sociedade de Investimento e Gestão SGPS (ELI:SEM) Can Manage Its Debt Responsibly

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. As with many other companies Semapa - Sociedade de Investimento e Gestão, SGPS, S.A. (ELI:SEM) makes use of debt. But the more important question is: how much risk is that debt creating?

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. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Semapa - Sociedade de Investimento e Gestão SGPS

How Much Debt Does Semapa - Sociedade de Investimento e Gestão SGPS Carry?

The image below, which you can click on for greater detail, shows that Semapa - Sociedade de Investimento e Gestão SGPS had debt of €1.50b at the end of December 2021, a reduction from €1.65b over a year. However, it also had €385.3m in cash, and so its net debt is €1.11b.

How Strong Is Semapa - Sociedade de Investimento e Gestão SGPS' Balance Sheet?

We can see from the most recent balance sheet that Semapa - Sociedade de Investimento e Gestão SGPS had liabilities of €996.4m falling due within a year, and liabilities of €1.53b due beyond that. Offsetting these obligations, it had cash of €385.3m as well as receivables valued at €422.1m due within 12 months. So it has liabilities totalling €1.72b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of €1.22b, we think shareholders really should watch Semapa - Sociedade de Investimento e Gestão SGPS's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

We'd say that Semapa - Sociedade de Investimento e Gestão SGPS's moderate net debt to EBITDA ratio ( being 2.1), indicates prudence when it comes to debt. And its commanding EBIT of 14.1 times its interest expense, implies the debt load is as light as a peacock feather. Notably, Semapa - Sociedade de Investimento e Gestão SGPS's EBIT launched higher than Elon Musk, gaining a whopping 110% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Semapa - Sociedade de Investimento e Gestão SGPS can strengthen its balance sheet over time. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Semapa - Sociedade de Investimento e Gestão SGPS actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Semapa - Sociedade de Investimento e Gestão SGPS's interest cover was a real positive on this analysis, as was its conversion of EBIT to free cash flow. In contrast, our confidence was undermined by its apparent struggle to handle its total liabilities. When we consider all the elements mentioned above, it seems to us that Semapa - Sociedade de Investimento e Gestão SGPS is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for Semapa - Sociedade de Investimento e Gestão SGPS you should be aware of, and 1 of them can't be ignored.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.