Direcional Engenharia (BVMF:DIRR3) Has A Pretty Healthy Balance Sheet

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Direcional Engenharia S.A. (BVMF:DIRR3) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Direcional Engenharia

What Is Direcional Engenharia's Net Debt?

As you can see below, Direcional Engenharia had R$1.31b of debt at September 2023, down from R$1.49b a year prior. However, it does have R$1.34b in cash offsetting this, leading to net cash of R$28.5m.

How Healthy Is Direcional Engenharia's Balance Sheet?

We can see from the most recent balance sheet that Direcional Engenharia had liabilities of R$942.6m falling due within a year, and liabilities of R$4.15b due beyond that. Offsetting this, it had R$1.34b in cash and R$699.2m in receivables that were due within 12 months. So its liabilities total R$3.06b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of R$3.22b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. While it does have liabilities worth noting, Direcional Engenharia also has more cash than debt, so we're pretty confident it can manage its debt safely.

Another good sign is that Direcional Engenharia has been able to increase its EBIT by 27% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Direcional Engenharia's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Direcional Engenharia has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Looking at the most recent three years, Direcional Engenharia recorded free cash flow of 31% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing Up

While Direcional Engenharia does have more liabilities than liquid assets, it also has net cash of R$28.5m. And we liked the look of last year's 27% year-on-year EBIT growth. So we are not troubled with Direcional Engenharia's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Direcional Engenharia you should be aware of.

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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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.