Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but the fact that you suffer a permanent loss of capital. “. So it can be obvious that you need to consider debt, when you think about how risky a given stock is because too much debt can sink a business. We note that Empresas Copec SA (SNSE: COPEC) has debt on its balance sheet. But should shareholders be concerned about its use of debt?
What risk does debt entail?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. Of course, debt can be an important tool in businesses, especially capital intensive businesses. When we look at debt levels, we first look at cash and debt levels together.
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What is Empresas Copec’s debt?
The graph below, which you can click for more details, shows that Empresas Copec had $ 8.70 billion in debt as of March 2021; about the same as the year before. However, it has US $ 2.03 billion in cash offsetting this, which leads to net debt of around US $ 6.66 billion.
How healthy is Empresas Copec’s balance sheet?
Zooming in on the latest balance sheet data, we can see that Empresas Copec had $ 2.96 billion in liabilities due within 12 months and $ 10.8 billion in liabilities due beyond. In return, he had $ 2.03 billion in cash and $ 2.07 billion in receivables due within 12 months. As a result, its liabilities exceed the sum of its cash and (short-term) receivables by $ 9.69 billion.
That’s a mountain of leverage, even compared to its gargantuan market cap of US $ 10.7 billion. If its lenders asked it to consolidate the balance sheet, shareholders would likely face severe dilution.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). Thus, we consider debt versus earnings with and without amortization charges.
Empresas Copec has a debt / EBITDA ratio of 3.7 and its EBIT covered its interest expense 3.4 times. Overall, this implies that while we wouldn’t like to see debt levels rise, we believe it can handle its current leverage. The good news is that Empresas Copec has increased its EBIT by 32% over the past twelve months. Like the milk of human kindness, this type of growth increases resilience, making the business more capable of handling debt. The balance sheet is clearly the area you need to focus on when analyzing debt. But it is future profits, more than anything, that will determine Empresas Copec’s ability to maintain a healthy balance sheet in the future. So, if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Empresas Copec has recorded a free cash flow of 11% of its EBIT, which is really quite low. This low level of cash conversion undermines its ability to manage and repay its debts.
Our point of view
Neither Empresas Copec’s ability to convert EBIT into free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is that he seems to be able to increase his EBIT with ease. In view of the above factors, we believe that Empresas Copec’s debt presents certain risks to the business. So while this leverage increases returns on equity, we wouldn’t really want to see it increase from here. The balance sheet is clearly the area you need to focus on when analyzing debt. However, not all investment risks lie on the balance sheet – far from it. For example, we discovered 2 warning signs for Empresas Copec (1 doesn’t suit us very well!) Which you should be aware of before investing here.
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
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