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. 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. As with many other companies Dynamatic Technologies Limited (NSE:DYNAMATECH) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company 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 and debt together.
What Is Dynamatic Technologies’s Net Debt?
As you can see below, Dynamatic Technologies had ₹6.05b of debt at September 2019, down from ₹6.35b a year prior. However, because it has a cash reserve of ₹406.7m, its net debt is less, at about ₹5.64b.
A Look At Dynamatic Technologies’s Liabilities
Zooming in on the latest balance sheet data, we can see that Dynamatic Technologies had liabilities of ₹6.12b due within 12 months and liabilities of ₹5.40b due beyond that. On the other hand, it had cash of ₹406.7m and ₹2.66b worth of receivables due within a year. So its liabilities total ₹8.45b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the ₹3.52b 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, Dynamatic Technologies would probably need a major re-capitalization if its creditors were to demand repayment.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
While we wouldn’t worry about Dynamatic Technologies’s net debt to EBITDA ratio of 3.3, we think its super-low interest cover of 1.5 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. The good news is that Dynamatic Technologies improved its EBIT by 3.7% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Dynamatic Technologies’s earnings that will influence how the balance sheet holds up in the future. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, Dynamatic Technologies produced sturdy free cash flow equating to 63% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
On the face of it, Dynamatic Technologies’s interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. Overall, we think it’s fair to say that Dynamatic Technologies has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. Be aware that Dynamatic Technologies is showing 3 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable…
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
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