Is Direcional Engenharia (BVMF:DIRR3) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Direcional Engenharia S.A. (BVMF:DIRR3) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Direcional Engenharia

How Much Debt Does Direcional Engenharia Carry?

The image below, which you can click on for greater detail, shows that at September 2020 Direcional Engenharia had debt of R$1.14b, up from R$900.2m in one year. However, it does have R$1.09b in cash offsetting this, leading to net debt of about R$45.2m.

A Look At Direcional Engenharia's Liabilities

Zooming in on the latest balance sheet data, we can see that Direcional Engenharia had liabilities of R$548.1m due within 12 months and liabilities of R$3.25b due beyond that. Offsetting these obligations, it had cash of R$1.09b as well as receivables valued at R$428.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$2.28b.

Given this deficit is actually higher than the company's market capitalization of R$2.13b, we think shareholders really should watch Direcional Engenharia's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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 Direcional Engenharia's low debt to EBITDA ratio of 0.21 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.3 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Importantly, Direcional Engenharia's EBIT fell a jaw-dropping 31% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. 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. So we always check how much of that EBIT is translated into free cash flow. During the last two years, Direcional Engenharia generated free cash flow amounting to a very robust 87% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

We feel some trepidation about Direcional Engenharia's difficulty EBIT growth rate, but we've got positives to focus on, too. To wit both its conversion of EBIT to free cash flow and net debt to EBITDA were encouraging signs. When we consider all the factors discussed, it seems to us that Direcional Engenharia is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Case in point: We've spotted 2 warning signs for Direcional Engenharia you should be aware of, and 1 of them is significant.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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