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.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We note that MRV Engenharia e Participações S.A. (BVMF:MRVE3) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
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What Is MRV Engenharia e Participações’s Net Debt?
As you can see below, at the end of September 2022, MRV Engenharia e Participações had R$7.07b of debt, up from R$5.05b a year ago. Click the image for more detail. On the flip side, it has R$2.85b in cash leading to net debt of about R$4.21b.
A Look At MRV Engenharia e Participações’ Liabilities
Zooming in on the latest balance sheet data, we can see that MRV Engenharia e Participações had liabilities of R$5.35b due within 12 months and liabilities of R$10.5b due beyond that. On the other hand, it had cash of R$2.85b and R$2.75b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$10.3b.
This deficit casts a shadow over the R$3.38b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, MRV Engenharia e Participações would probably need a major re-capitalization if its creditors were to demand repayment.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).
MRV Engenharia e Participações has a rather high debt to EBITDA ratio of 28.5 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 3.4 times, suggesting it can responsibly service its obligations. Worse, MRV Engenharia e Participações’s EBIT was down 86% over the last year. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine MRV Engenharia e Participações’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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, MRV Engenharia e Participações burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
To be frank both MRV Engenharia e Participações’s EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And furthermore, its net debt to EBITDA also fails to instill confidence. Considering everything we’ve mentioned above, it’s fair to say that MRV Engenharia e Participações is carrying heavy debt load. If you harvest honey without a bee suit, you risk getting stung, so we’d probably stay away from this particular stock. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. These risks can be hard to spot. Every company has them, and we’ve spotted 4 warning signs for MRV Engenharia e Participações (of which 1 is concerning!) you should know about.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.