Does Guararapes Confecções (BVMF:GUAR3) have a healthy balance sheet?

Howard Marks said it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and that every practical investor that I know is worried”. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. Above all, Guararapes Confecções SA (BVMF:GUAR3) is in debt. But the real question is whether this debt makes the business risky.

Why is debt risky?

Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. If things go really bad, lenders can take over the business. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business has is to look at its cash and debt together.

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What is the debt of Guararapes Confecções?

You can click on the graph below for historical figures, but it shows that in June 2022, Guararapes Confecções had a debt of R$3.64 billion, an increase from R$3.47 billion, over a year. However, he has 1.27 billion reais in cash to offset this, resulting in a net debt of around 2.37 billion reais.

BOVESPA:GUAR3 Debt to equity Historical September 18, 2022

How healthy is Guararapes Confecções’ balance sheet?

We can see from the most recent balance sheet that Guararapes Confecções had liabilities of 5.83 billion reais due in one year, and liabilities of 3.15 billion reais due beyond. In compensation for these obligations, it had cash of R$1.27 billion as well as receivables valued at R$5.71 billion maturing within 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables of 2.00 billion reais.

While that might sound like a lot, it’s not too bad since Guararapes Confecções has a market capitalization of R$4.60 billion, so it could probably strengthen its balance sheet by raising capital if needed. But it is clear that it is essential to examine closely whether it can manage its debt without dilution.

We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). Thus, we consider debt to earnings with and without amortization and depreciation expense.

While we are not concerned about Guararapes Confecções’ net debt to EBITDA ratio of 4.3, we believe that its extremely low interest coverage of 1.0 times is a sign of high leverage. Shareholders should therefore probably be aware that interest charges seem to have had a real impact on the company lately. On a slightly more positive note, Guararapes Confecções increased its EBIT by 18% compared to last year, further increasing its ability to manage debt. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Guararapes Confecções can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Guararapes Confecções has recorded free cash flow representing 78% of its EBIT, which is about normal, given that free cash flow excludes interest and taxes. This free cash flow puts the company in a good position to repay its debt, should it arise.

Our point of view

From what we’ve seen, Guararapes Confecções doesn’t find it easy, given its interest coverage, but the other factors we’ve considered give us cause for optimism. There’s no doubt that its ability to convert EBIT to free cash flow is pretty dazzling. When considering all the elements mentioned above, it seems to us that Guararapes Confecções manages its debt quite well. But be warned: we believe debt levels are high enough to warrant continued monitoring. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks reside on the balance sheet, far from it. For example, we have identified 4 warning signs for Guararapes Confecções (1 makes us a little uneasy) that you should be aware of.

In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.

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