Here's Why São Martinho (BVMF:SMTO3) Has A Meaningful Debt Burden

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We can see that São Martinho S.A. (BVMF:SMTO3) does use debt in its business. But should shareholders be worried about its use of debt?

Our free stock report includes 2 warning signs investors should be aware of before investing in São Martinho. Read for free now.

When Is Debt A Problem?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is São Martinho's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2024 São Martinho had debt of R$8.65b, up from R$6.55b in one year. However, it does have R$3.26b in cash offsetting this, leading to net debt of about R$5.39b.

How Healthy Is São Martinho's Balance Sheet?

According to the last reported balance sheet, São Martinho had liabilities of R$3.34b due within 12 months, and liabilities of R$12.5b due beyond 12 months. Offsetting this, it had R$3.26b in cash and R$1.09b in receivables that were due within 12 months. So its liabilities total R$11.5b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the R$6.92b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, São Martinho would probably need a major re-capitalization if its creditors were to demand repayment.

View our latest analysis for São Martinho

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While São Martinho's low debt to EBITDA ratio of 1.3 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.6 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. One way São Martinho could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 19%, as it did over the last year. 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 São Martinho'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, São Martinho's free cash flow amounted to 27% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

We'd go so far as to say São Martinho's level of total liabilities was disappointing. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that São Martinho's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Be aware that São Martinho is showing 2 warning signs in our investment analysis , you should know about...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.