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 Afya Limited (NASDAQ:AFYA) does use debt in its business. 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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Afya Carry?
As you can see below, at the end of June 2020, Afya had R$139.8m of debt, up from R$98.5m a year ago. Click the image for more detail. However, it does have R$1.05b in cash offsetting this, leading to net cash of R$910.3m.
A Look At Afya's Liabilities
According to the last reported balance sheet, Afya had liabilities of R$462.5m due within 12 months, and liabilities of R$728.1m due beyond 12 months. Offsetting these obligations, it had cash of R$1.05b as well as receivables valued at R$257.6m due within 12 months. So it actually has R$117.2m more liquid assets than total liabilities.
This state of affairs indicates that Afya's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the R$12.8b company is struggling for cash, we still think it's worth monitoring its balance sheet. Succinctly put, Afya boasts net cash, so it's fair to say it does not have a heavy debt load!
On top of that, Afya grew its EBIT by 90% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Afya can strengthen its balance sheet over time. 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. Afya may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Afya produced sturdy free cash flow equating to 77% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
While we empathize with investors who find debt concerning, you should keep in mind that Afya has net cash of R$910.3m, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 90% over the last year. So we don't think Afya's use of debt is risky. 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. Case in point: We've spotted 1 warning sign for Afya you should be aware of.
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. 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.
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