Mecanica Fina (BVB:MECE) Use Of Debt Could Be Considered Risky

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.' 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 Mecanica Fina SA (BVB:MECE) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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, 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.

Check out our latest analysis for Mecanica Fina

How Much Debt Does Mecanica Fina Carry?

As you can see below, Mecanica Fina had RON16.6m of debt at December 2020, down from RON25.6m a year prior. And it doesn't have much cash, so its net debt is about the same.

A Look At Mecanica Fina's Liabilities

Zooming in on the latest balance sheet data, we can see that Mecanica Fina had liabilities of RON6.19m due within 12 months and liabilities of RON40.1m due beyond that. Offsetting this, it had RON269.5k in cash and RON4.47m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by RON41.5m.

When you consider that this deficiency exceeds the company's RON36.0m market capitalization, you might well be inclined to review the balance sheet intently. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Mecanica Fina shareholders face the double whammy of a high net debt to EBITDA ratio (6.8), and fairly weak interest coverage, since EBIT is just 0.72 times the interest expense. The debt burden here is substantial. Even worse, Mecanica Fina saw its EBIT tank 79% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Mecanica Fina's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. In the last three years, Mecanica Fina's free cash flow amounted to 32% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

On the face of it, Mecanica Fina's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its conversion of EBIT to free cash flow is not so bad. Taking into account all the aforementioned factors, it looks like Mecanica Fina has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example Mecanica Fina has 4 warning signs (and 1 which is significant) we think you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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