Is Diagnósticos da América (BVMF:DASA3) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. As with many other companies Diagnósticos da América S.A. (BVMF:DASA3) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Diagnósticos da América

What Is Diagnósticos da América's Net Debt?

As you can see below, at the end of September 2023, Diagnósticos da América had R$11.4b of debt, up from R$10.0b a year ago. Click the image for more detail. On the flip side, it has R$1.33b in cash leading to net debt of about R$10.0b.

How Strong Is Diagnósticos da América's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Diagnósticos da América had liabilities of R$6.41b due within 12 months and liabilities of R$12.7b due beyond that. On the other hand, it had cash of R$1.33b and R$5.21b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$12.6b.

This deficit casts a shadow over the R$6.80b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Diagnósticos da América would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 0.68 times and a disturbingly high net debt to EBITDA ratio of 6.0 hit our confidence in Diagnósticos da América like a one-two punch to the gut. The debt burden here is substantial. Looking on the bright side, Diagnósticos da América boosted its EBIT by a silky 33% in the last year. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Diagnósticos da América burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Diagnósticos da América's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities 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. We should also note that Healthcare industry companies like Diagnósticos da América commonly do use debt without problems. Overall, it seems to us that Diagnósticos da América's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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, we've discovered 2 warning signs for Diagnósticos da América 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.