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.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that EVERTEC, Inc. (NYSE:EVTC) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is EVERTEC’s Net Debt?

The chart below, which you can click on for greater detail, shows that EVERTEC had US$520.9m in debt in December 2020; about the same as the year before. However, because it has a cash reserve of US$202.6m, its net debt is less, at about US$318.2m.

How Strong Is EVERTEC’s Balance Sheet?

We can see from the most recent balance sheet that EVERTEC had liabilities of US$153.0m falling due within a year, and liabilities of US$577.2m due beyond that. On the other hand, it had cash of US$202.6m and US$87.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$439.8m.

Since publicly traded EVERTEC shares are worth a total of US$2.95b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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.

EVERTEC has net debt worth 1.7 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 6.0 times the interest expense. While these numbers do not alarm us, it’s worth noting that the cost of the company’s debt is having a real impact. Sadly, EVERTEC’s EBIT actually dropped 2.1% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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 EVERTEC’s ability to maintain a healthy balance sheet going forward.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, EVERTEC recorded free cash flow worth a fulsome 98% of its EBIT, which is stronger than we’d usually expect. That puts it in a very strong position to pay down debt.

Our View

The good news is that EVERTEC’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its EBIT growth rate. Looking at all the aforementioned factors together, it strikes us that EVERTEC can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one. 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.