Semapa - Sociedade de Investimento e Gestão SGPS (ELI:SEM) Takes On Some Risk With Its Use Of Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Semapa - Sociedade de Investimento e Gestão, SGPS, S.A. (ELI:SEM) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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.

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

What Is Semapa - Sociedade de Investimento e Gestão SGPS's Debt?

The image below, which you can click on for greater detail, shows that Semapa - Sociedade de Investimento e Gestão SGPS had debt of €1.65b at the end of March 2021, a reduction from €2.16b over a year. However, it also had €501.0m in cash, and so its net debt is €1.15b.

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

According to the last reported balance sheet, Semapa - Sociedade de Investimento e Gestão SGPS had liabilities of €1.15b due within 12 months, and liabilities of €1.52b due beyond 12 months. On the other hand, it had cash of €501.0m and €302.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €1.87b.

The deficiency here weighs heavily on the €932.9m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Semapa - Sociedade de Investimento e Gestão 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Semapa - Sociedade de Investimento e Gestão SGPS has a debt to EBITDA ratio of 3.2 and its EBIT covered its interest expense 4.7 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. The bad news is that Semapa - Sociedade de Investimento e Gestão SGPS saw its EBIT decline by 14% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Semapa - Sociedade de Investimento e Gestão SGPS'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Semapa - Sociedade de Investimento e Gestão SGPS actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Mulling over Semapa - Sociedade de Investimento e Gestão SGPS's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, we think it's fair to say that Semapa - Sociedade de Investimento e Gestão SGPS has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 4 warning signs with Semapa - Sociedade de Investimento e Gestão SGPS (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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