Is Arco Platform (NASDAQ:ARCE) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Arco Platform Limited (NASDAQ:ARCE) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.

See our latest analysis for Arco Platform

How Much Debt Does Arco Platform Carry?

As you can see below, at the end of December 2020, Arco Platform had R$311.1m of debt, up from R$98.6m a year ago. Click the image for more detail. But on the other hand it also has R$1.14b in cash, leading to a R$825.9m net cash position.

How Healthy Is Arco Platform's Balance Sheet?

According to the last reported balance sheet, Arco Platform had liabilities of R$980.3m due within 12 months, and liabilities of R$1.40b due beyond 12 months. Offsetting these obligations, it had cash of R$1.14b as well as receivables valued at R$444.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$793.8m.

Given Arco Platform has a market capitalization of R$9.63b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Arco Platform also has more cash than debt, so we're pretty confident it can manage its debt safely.

It is well worth noting that Arco Platform's EBIT shot up like bamboo after rain, gaining 65% in the last twelve months. That'll make it easier to manage its debt. 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're focused on the future you can check out this free report showing analyst profit forecasts.

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. Over the last three years, Arco Platform recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

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$825.9m. And we liked the look of last year's 65% year-on-year EBIT growth. So we are not troubled with Arco Platform's debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Arco Platform is showing 3 warning signs in our investment analysis , you should know about...

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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