Here's Why Dynamic Group Holdings (ASX:DDB) Can Manage Its Debt Responsibly

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.' 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 Dynamic Group Holdings Limited (ASX:DDB) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Dynamic Group Holdings

How Much Debt Does Dynamic Group Holdings Carry?

As you can see below, Dynamic Group Holdings had AU$26.6m of debt at December 2023, down from AU$28.1m a year prior. However, it does have AU$10.3m in cash offsetting this, leading to net debt of about AU$16.3m.

How Healthy Is Dynamic Group Holdings' Balance Sheet?

We can see from the most recent balance sheet that Dynamic Group Holdings had liabilities of AU$20.5m falling due within a year, and liabilities of AU$22.0m due beyond that. Offsetting this, it had AU$10.3m in cash and AU$11.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$21.2m.

This deficit is considerable relative to its market capitalization of AU$25.7m, so it does suggest shareholders should keep an eye on Dynamic Group Holdings' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). 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 Dynamic Group Holdings's low debt to EBITDA ratio of 0.85 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.8 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. We also note that Dynamic Group Holdings improved its EBIT from a last year's loss to a positive AU$5.6m. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Dynamic Group Holdings's earnings that will influence how the balance sheet holds up in the future. 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, Dynamic Group Holdings actually produced more free cash flow than EBIT over the last year. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

On our analysis Dynamic Group Holdings's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its interest cover makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Dynamic Group Holdings's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. For example, we've discovered 2 warning signs for Dynamic Group Holdings that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.

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