Diagnósticos da América (BVMF:DASA3) Has A Somewhat Strained Balance Sheet

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.' 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 note that Diagnósticos da América S.A. (BVMF:DASA3) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Diagnósticos da América

What Is Diagnósticos da América's Debt?

The image below, which you can click on for greater detail, shows that at March 2021 Diagnósticos da América had debt of R$5.83b, up from R$3.92b in one year. However, it does have R$751.1m in cash offsetting this, leading to net debt of about R$5.08b.

A Look At Diagnósticos da América's Liabilities

Zooming in on the latest balance sheet data, we can see that Diagnósticos da América had liabilities of R$3.95b due within 12 months and liabilities of R$6.55b due beyond that. Offsetting these obligations, it had cash of R$751.1m as well as receivables valued at R$2.43b due within 12 months. So its liabilities total R$7.31b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Diagnósticos da América has a market capitalization of R$31.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without 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).

Weak interest cover of 0.60 times and a disturbingly high net debt to EBITDA ratio of 9.0 hit our confidence in Diagnósticos da América like a one-two punch to the gut. The debt burden here is substantial. Worse, Diagnósticos da América's EBIT was down 32% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Diagnósticos da América'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Diagnósticos da América recorded free cash flow worth a fulsome 89% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Neither Diagnósticos da América's ability to grow its EBIT nor its interest cover gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. It's also worth noting that Diagnósticos da América is in the Healthcare industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think Diagnósticos da América's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with Diagnósticos da América (including 1 which doesn't sit too well with us) .

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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