Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. 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. We note that Plaza S.A. (SNSE:MALLPLAZA) has debt on its balance sheet. But the real question is whether this debt makes the business risky.
Why is debt risky?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. 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. When we think about a company’s use of debt, we first look at cash and debt together.
See our latest analysis for Plaza
What is Plaza’s debt?
You can click on the graph below for historical numbers, but it shows that in June 2022, Plaza had debt of CL$1.12t, an increase of CL$1.02t, year-over-year. However, since it has a cash reserve of CL$142.8 billion, its net debt is less, at around CL$979.7 billion.
How strong is Plaza’s balance sheet?
The latest balance sheet data shows that Plaza had liabilities of CL$179.7 billion due within the year, and liabilities of CL$1.52 billion falling due thereafter. In return, it had CL$142.8 billion in cash and CL$160.4 billion in receivables due within 12 months. Thus, its liabilities total CL$1.40 t more than the combination of its cash and short-term receivables.
This is a mountain of leverage compared to its market cap of CL$1.98t. If its lenders asked it to shore up its balance sheet, shareholders would likely face significant 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.
Plaza’s debt is 3.9 times its EBITDA and its EBIT covers its interest expense 5.3 times. Taken together, this implies that, while we wouldn’t like to see debt levels increase, we think he can manage his current leverage. Notably, Plaza’s EBIT launched higher than Elon Musk, gaining 135% from a year ago. When analyzing debt levels, the balance sheet is the obvious starting point. But it’s future earnings, more than anything, that will determine Plaza’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.
But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, Plaza has actually produced more free cash flow than EBIT. This kind of high cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Our point of view
Plaza’s conversion of EBIT to free cash flow suggests it can manage its debt as easily as Cristiano Ronaldo could score a goal against an Under-14 goalkeeper. But, on a darker note, we’re a bit concerned about its net debt to EBITDA. Looking at all of the aforementioned factors together, it seems to us that Plaza can manage its debt quite comfortably. On the plus side, this leverage can increase shareholder returns, but the potential downside is more risk of loss, so it’s worth keeping an eye on the balance sheet. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside on the balance sheet, far from it. These risks can be difficult to spot. Every business has them, and we’ve spotted 1 warning sign for Plaza you should know.
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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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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