Here's Why Diagnósticos da América (BVMF:DASA3) Has A Meaningful Debt Burden

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Diagnósticos da América S.A. (BVMF:DASA3) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Diagnósticos da América

How Much Debt Does Diagnósticos da América Carry?

The image below, which you can click on for greater detail, shows that at March 2022 Diagnósticos da América had debt of R$9.30b, up from R$5.83b in one year. However, it does have R$1.03b in cash offsetting this, leading to net debt of about R$8.26b.

A Look At Diagnósticos da América's Liabilities

The latest balance sheet data shows that Diagnósticos da América had liabilities of R$6.39b due within a year, and liabilities of R$10.6b falling due after that. Offsetting these obligations, it had cash of R$1.03b as well as receivables valued at R$3.28b due within 12 months. So it has liabilities totalling R$12.6b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of R$9.79b, we think shareholders really should watch Diagnósticos da América'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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Diagnósticos da América shareholders face the double whammy of a high net debt to EBITDA ratio (10.0), and fairly weak interest coverage, since EBIT is just 0.59 times the interest expense. This means we'd consider it to have a heavy debt load. The good news is that Diagnósticos da América grew its EBIT a smooth 84% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Diagnósticos da América can strengthen its balance sheet over time. 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 it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Diagnósticos da América recorded free cash flow of 39% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

On the face of it, Diagnósticos da América's net debt to EBITDA left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. It's also worth noting that Diagnósticos da América is in the Healthcare industry, which is often considered to be quite defensive. Once we consider all the factors above, together, it seems to us that Diagnósticos da América's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. For example Diagnósticos da América has 2 warning signs (and 1 which can't be ignored) we think you should know about.

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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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.