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.' 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. Importantly, Cofina, SGPS, S.A. (ELI:CFN) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Cofina SGPS's Debt?
As you can see below, at the end of December 2020, Cofina SGPS had €55.3m of debt, up from €52.1m a year ago. Click the image for more detail. On the flip side, it has €15.3m in cash leading to net debt of about €39.9m.
How Healthy Is Cofina SGPS' Balance Sheet?
The latest balance sheet data shows that Cofina SGPS had liabilities of €77.0m due within a year, and liabilities of €10.3m falling due after that. Offsetting this, it had €15.3m in cash and €8.68m in receivables that were due within 12 months. So it has liabilities totalling €63.3m more than its cash and near-term receivables, combined.
This deficit casts a shadow over the €24.7m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Cofina SGPS would likely require a major re-capitalisation if it had to pay its creditors today.
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). 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).
With net debt to EBITDA of 3.9 Cofina SGPS has a fairly noticeable amount of debt. On the plus side, its EBIT was 7.0 times its interest expense, and its net debt to EBITDA, was quite high, at 3.9. Importantly, Cofina SGPS's EBIT fell a jaw-dropping 31% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Cofina 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Cofina SGPS recorded free cash flow worth a fulsome 85% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
To be frank both Cofina SGPS's EBIT growth rate and its track record of staying on top of its total liabilities 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. We're quite clear that we consider Cofina SGPS to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. Case in point: We've spotted 4 warning signs for Cofina SGPS you should be aware of, and 1 of them is significant.
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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