Arco Platform (NASDAQ:ARCE) Seems To Use Debt Quite Sensibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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, Arco Platform Limited (NASDAQ:ARCE) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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

See our latest analysis for Arco Platform

What Is Arco Platform's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Arco Platform had R$302.8m of debt, an increase on R$510.0k, over one year. However, it does have R$1.43b in cash offsetting this, leading to net cash of R$1.13b.

A Look At Arco Platform's Liabilities

We can see from the most recent balance sheet that Arco Platform had liabilities of R$594.9m falling due within a year, and liabilities of R$1.26b due beyond that. On the other hand, it had cash of R$1.43b and R$288.3m worth of receivables due within a year. So it has liabilities totalling R$136.5m more than its cash and near-term receivables, combined.

Having regard to Arco Platform's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the R$10.6b company is struggling for cash, we still think it's worth monitoring its balance sheet. Despite its noteworthy liabilities, Arco Platform boasts net cash, so it's fair to say it does not have a heavy debt load!

Pleasingly, Arco Platform is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 226% gain in the last twelve months. 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 Arco Platform'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. Arco Platform 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. Looking at the most recent three years, Arco Platform recorded free cash flow of 21% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Summing up

We could understand if investors are concerned about Arco Platform's liabilities, but we can be reassured by the fact it has has net cash of R$1.13b. And it impressed us with its EBIT growth of 226% over the last year. So we are not troubled with Arco Platform's debt use. 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 2 warning signs for Arco Platform you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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