Is Diagnósticos da América (BVMF:DASA3) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Diagnósticos da América S.A. (BVMF:DASA3) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Diagnósticos da América

What Is Diagnósticos da América's Net Debt?

As you can see below, at the end of June 2023, Diagnósticos da América had R$11.1b of debt, up from R$9.93b a year ago. Click the image for more detail. On the flip side, it has R$1.54b in cash leading to net debt of about R$9.60b.

A Look At Diagnósticos da América's Liabilities

We can see from the most recent balance sheet that Diagnósticos da América had liabilities of R$7.86b falling due within a year, and liabilities of R$11.4b due beyond that. Offsetting these obligations, it had cash of R$1.54b as well as receivables valued at R$4.89b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$12.8b.

Given this deficit is actually higher than the company's market capitalization of R$9.91b, 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. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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 0.69 times and a disturbingly high net debt to EBITDA ratio of 5.8 hit our confidence in Diagnósticos da América like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Looking on the bright side, Diagnósticos da América boosted its EBIT by a silky 38% 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. When analysing debt levels, the balance sheet is the obvious place to start. 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.

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. Over the last three years, Diagnósticos da América saw substantial negative free cash flow, in total. 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

To be frank both Diagnósticos da América's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. It's also worth noting that Diagnósticos da América is in the Healthcare industry, which is often considered to be quite defensive. We're quite clear that we consider Diagnósticos da América to be really rather risky, as a result of its balance sheet health. 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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Diagnósticos da América you should know about.

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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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.