We Think PagSeguro Digital (NYSE:PAGS) Can Stay On Top Of Its Debt

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies PagSeguro Digital Ltd. (NYSE:PAGS) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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.

Our analysis indicates that PAGS is potentially undervalued!

What Is PagSeguro Digital's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 PagSeguro Digital had R$1.35b of debt, an increase on none, over one year. However, because it has a cash reserve of R$1.19b, its net debt is less, at about R$157.1m.

How Strong Is PagSeguro Digital's Balance Sheet?

The latest balance sheet data shows that PagSeguro Digital had liabilities of R$24.7b due within a year, and liabilities of R$3.33b falling due after that. On the other hand, it had cash of R$1.19b and R$31.7b worth of receivables due within a year. So it actually has R$4.85b more liquid assets than total liabilities.

It's good to see that PagSeguro Digital has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Because it has plenty of assets, it is unlikely to have trouble with its lenders. But either way, PagSeguro Digital has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). 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).

PagSeguro Digital's net debt to EBITDA ratio is very low, at 0.035, suggesting the debt is only trivial. Although with EBIT only covering interest expenses 4.7 times over, the company is truly paying for borrowing. Notably, PagSeguro Digital's EBIT launched higher than Elon Musk, gaining a whopping 118% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine PagSeguro Digital'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, PagSeguro Digital recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Happily, PagSeguro Digital's impressive EBIT growth rate implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. When we consider the range of factors above, it looks like PagSeguro Digital is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. For example, we've discovered 2 warning signs for PagSeguro Digital (1 is a bit unpleasant!) that you should be aware of before investing here.

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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.