Legendary fund manager Li Lu (who Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. So it can be obvious that you need to consider debt, when you think about how risky a given stock is because too much debt can sink a business. Above all, Iochpe-Maxion SA (BVMF: MYPK3) carries a debt. But should shareholders be concerned about its use of debt?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that he must raise new equity at low cost, thereby diluting shareholders over the long term. 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 look at debt levels, we first consider both liquidity and debt levels.
See our latest review for Iochpe-Maxion
What is the debt of Iochpe-Maxion?
As you can see below, at the end of June 2021, Iochpe-Maxion had a debt of R $ 5.37 billion, up from R $ 5.03 billion a year ago. Click on the image for more details. On the other hand, he has 1.38 billion reais in cash, resulting in a net debt of around 3.99 billion reais.
How strong is Iochpe-Maxion’s balance sheet?
We can see from the most recent balance sheet that Iochpe-Maxion had liabilities of 4.78 billion reais due within one year and liabilities of 4.53 billion reais due beyond. In compensation for these obligations, it had cash of R $ 1.38 billion as well as claims valued at R $ 2.14 billion due within 12 months. Thus, its liabilities exceed the sum of its cash and (short-term) receivables by 5.79 billion reais.
This deficit casts a shadow over the 2.32 billion reais society, like a colossus towering over mere mortals. We therefore believe that shareholders should watch it closely. After all, Iochpe-Maxion would likely need a major recapitalization if it were to pay its creditors today.
In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Iochpe-Maxion has a debt to EBITDA ratio of 2.9 and its EBIT has covered its interest expense 4.1 times. This suggests that while debt levels are significant, we would stop calling them problematic. However, it should be heartwarming for shareholders to remember that Iochpe-Maxion has in fact increased its EBIT by 1,052%, over the past 12 months. If he can continue on this path, he will be able to deleverage with relative ease. The balance sheet is clearly the area you need to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Iochpe-Maxion 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.
Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. We therefore always check how much of this EBIT is converted into free cash flow. In the past three years, Iochpe-Maxion has barely recorded any positive free cash flow, in total. While many businesses are operating at breakeven, we prefer to see substantial free cash flow, especially if they are already dead.
Our point of view
We would go so far as to say that Iochpe-Maxion’s total liability level was disappointing. But at least it’s decent enough to increase your EBIT; it’s encouraging. Looking at the big picture, it seems clear to us that Iochpe-Maxion’s use of debt creates risks for the company. If all goes well, this should increase returns, but on the other hand, the risk of permanent capital loss is increased by debt. The balance sheet is clearly the area you need to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist off the balance sheet. For example Iochpe-Maxion has 2 warning signs (and 1 which is a bit disturbing) we think you should be aware of.
At the end of the day, it’s often best to focus on businesses with no net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
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