These 4 Measures Indicate That Diagnósticos da América (BVMF:DASA3) Is Using Debt Extensively

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Diagnósticos da América S.A. (BVMF:DASA3) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 September 2020 Diagnósticos da América had debt of R$4.75b, up from R$2.67b in one year. However, it does have R$444.4m in cash offsetting this, leading to net debt of about R$4.31b.

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$2.55b falling due within a year, and liabilities of R$5.97b due beyond that. Offsetting these obligations, it had cash of R$444.4m as well as receivables valued at R$2.00b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$6.08b.

Of course, Diagnósticos da América has a market capitalization of R$33.7b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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).

Diagnósticos da América shareholders face the double whammy of a high net debt to EBITDA ratio (14.7), and fairly weak interest coverage, since EBIT is just 0.33 times the interest expense. This means we'd consider it to have a heavy debt load. Even worse, Diagnósticos da América saw its EBIT tank 79% over the last 12 months. 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 Diagnósticos da América's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Diagnósticos da América recorded free cash flow of 40% 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 interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its level of total liabilities is not so bad. It's also worth noting that Diagnósticos da América is in the Healthcare industry, which is often considered to be quite defensive. Looking at the bigger picture, it seems clear to us that Diagnósticos da América's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. Be aware that Diagnósticos da América is showing 4 warning signs in our investment analysis , and 3 of those shouldn't be ignored...

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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