Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Cofina, SGPS, S.A. (ELI:CFN) makes use of debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company 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.
What Is Cofina SGPS's Debt?
The chart below, which you can click on for greater detail, shows that Cofina SGPS had €57.3m in debt in June 2019; about the same as the year before. However, it also had €14.9m in cash, and so its net debt is €42.4m.
How Strong Is Cofina SGPS's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Cofina SGPS had liabilities of €79.8m due within 12 months and liabilities of €14.9m due beyond that. Offsetting these obligations, it had cash of €14.9m as well as receivables valued at €12.9m due within 12 months. So its liabilities total €66.9m more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the €37.5m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet." So we definitely think shareholders need to watch this one closely. After all, Cofina SGPS would likely require a major re-capitalisation if it had to pay its creditors today.
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).
With net debt to EBITDA of 2.7 Cofina SGPS has a fairly noticeable amount of debt. But the high interest coverage of 8.1 suggests it can easily service that debt. We saw Cofina SGPS grow its EBIT by 4.8% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Cofina SGPS'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Cofina SGPS produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Cofina SGPS's level of total liabilities was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its conversion of EBIT to free cash flow was refreshing. Taking the abovementioned factors together we do think Cofina SGPS's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Cofina SGPS's earnings per share history for free.
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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