Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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 Empresas CMPC S.A makes use of debt. But is this debt a concern to shareholders?.
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
As you can see below, Empresas CMPC had US$4.44b of debt, at September 2022, which is about the same as the year before. You can click the chart for greater detail. However, it does have US$638.1m in cash offsetting this, leading to net debt of about US$3.81b.
We can see from the most recent balance sheet that Empresas CMPC had liabilities of US$2.10b falling due within a year, and liabilities of US$5.86b due beyond that. Offsetting these obligations, it had cash of US$638.1m as well as receivables valued at US$1.61b due within 12 months. So its liabilities total US$5.72b more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company’s market capitalization of US$4.10b, we think shareholders really should watch Empresas CMPC’s debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Empresas CMPC’s net debt is sitting at a very reasonable 2.4 times its EBITDA, while its EBIT covered its interest expense just 6.3 times last year. While these numbers do not alarm us, it’s worth noting that the cost of the company’s debt is having a real impact. Importantly-
Empresas CMPC grew its EBIT by 44% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Empresas CMPC can strengthen its balance sheet over time. So if you’re focused on the future you can-
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Empresas CMPC recorded free cash flow worth a fulsome 93% of its EBIT, which is stronger than we’d usually expect. That positions it well to pay down debt if desirable to do so.
Both Empresas CMPC’s ability to to convert EBIT to free cash flow and its EBIT growth rate gave us comfort that it can handle its debt. But truth be told its level of total liabilities had us nibbling our nails. When we consider all the factors mentioned above, we do feel a bit cautious about Empresas CMPC’s use of debt. While debt does have its upside in higher potential.
returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. Case in point: We’ve spotted you should be aware of, and 1 of them is potentially serious.
Empresas CMPC S.A. engages in the production and marketing of wood, pulp, packaging, household and non-household sanitary protection, and tissue paper products in Chile and internationally.
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Solid track record with adequate balance sheet and pays a dividend.
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