Does Falabella (SNSE: FALABELLA) have a healthy track record?

Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but whether 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, Falabella SA (SNSE: FALABELLA) is in debt. But the most important question is: what risk does this debt create?

When is debt dangerous?

Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. 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. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.

See our latest review for Falabella

What is Falabella’s net debt?

As you can see below, Falabella had a debt of 4.31 CL tonnes in June 2021, up from 5.47 CL the year before. However, he also had CL $ 840.6 billion in cash, so his net debt is CL $ 3.47 billion.

SNSE: FALABELLA History of debt on equity October 18, 2021

How strong is Falabella’s balance sheet?

We can see from the most recent balance sheet that Falabella had a liability of 2.76 t CL due within one year and a liability of 9.54 t CL beyond. On the other hand, he had cash of CL $ 840.6 billion and receivables worth CL $ 419.3 billion within a year. It therefore has liabilities totaling CL $ 11,000 more than its cash and short-term receivables combined.

This deficit casts a shadow over the CL $ 5.93t company, like a towering colossus of mere mortals. We therefore believe that shareholders should watch it closely. Ultimately, Falabella would likely need a major recapitalization if her creditors demanded repayment.

We measure a company’s debt load relative to its earning capacity 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 costs (interest coverage). Thus, we consider debt versus earnings with and without amortization charges.

Falabella’s debt is 3.0 times its EBITDA and its EBIT covers its interest expense 4.9 times. This suggests that while debt levels are significant, we would stop calling them problematic. Fortunately, Falabella is increasing its EBIT faster than former Australian Prime Minister Bob Hawke, gaining 218% in the past twelve months. There is no doubt that we learn the most about debt from the balance sheet. But it’s future profits, more than anything, that will determine Falabella’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.

Finally, a business can only pay off its debts with hard cash, not with book profits. It is therefore worth checking to what extent this EBIT is supported by free cash flow. In the past three years, Falabella has actually generated more free cash flow than EBIT. There is nothing better than cash flow to stay in the good graces of your lenders.

Our point of view

Whereas Falabella’s total passive level makes us nervous. Its conversion of EBIT to free cash flow and the growth rate of EBIT were encouraging signs. Looking at all the angles mentioned above, it seems to us that Falabella is a somewhat risky investment because of its debt. Not all risks are bad, as they can increase stock price returns if they are profitable, but this risk of leverage is worth keeping in mind. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, we discovered 2 warning signs for Falabella which you should know before investing here.

If you are interested in investing in companies that can generate profits without the burden of debt, check out this page free list of growing companies that have net cash on the balance sheet.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.

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