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. We can see that Dangee Dums Limited (NSE:DANGEE) does use debt in its business. But the real question is whether this debt is making the company risky.
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Dangee Dums’s Net Debt?
As you can see below, Dangee Dums had ₹153.5m of debt at March 2019, down from ₹288.0m a year prior. However, because it has a cash reserve of ₹72.5m, its net debt is less, at about ₹81.0m.
A Look At Dangee Dums’s Liabilities
Zooming in on the latest balance sheet data, we can see that Dangee Dums had liabilities of ₹91.9m due within 12 months and liabilities of ₹104.7m due beyond that. Offsetting these obligations, it had cash of ₹72.5m as well as receivables valued at ₹29.3m due within 12 months. So its liabilities total ₹94.8m more than the combination of its cash and short-term receivables.
Of course, Dangee Dums has a market capitalization of ₹1.54b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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).
Given net debt is only 0.95 times EBITDA, it is initially surprising to see that Dangee Dums’s EBIT has low interest coverage of 1.2 times. So while we’re not necessarily alarmed we think that its debt is far from trivial. Shareholders should be aware that Dangee Dums’s EBIT was down 37% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since Dangee Dums will need earnings to service that debt. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
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. During the last three years, Dangee Dums burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Dangee Dums’s conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its level of total liabilities is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Dangee Dums’s use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you’ve also come to that realization, you’re in luck, because today you can view this interactive graph of Dangee Dums’s earnings per share history for free.
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.
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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.