DATA Communications Management (TSE:DCM) Seems To Use Debt Quite Sensibly

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.' 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. Importantly, DATA Communications Management Corp. (TSE:DCM) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. 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.

See our latest analysis for DATA Communications Management

What Is DATA Communications Management's Debt?

You can click the graphic below for the historical numbers, but it shows that DATA Communications Management had CA$40.4m of debt in March 2021, down from CA$83.5m, one year before. Net debt is about the same, since the it doesn't have much cash.

How Healthy Is DATA Communications Management's Balance Sheet?

We can see from the most recent balance sheet that DATA Communications Management had liabilities of CA$60.7m falling due within a year, and liabilities of CA$81.7m due beyond that. Offsetting these obligations, it had cash of CA$599.0k as well as receivables valued at CA$60.2m due within 12 months. So it has liabilities totalling CA$81.6m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of CA$65.0m, we think shareholders really should watch DATA Communications Management'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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While DATA Communications Management has a quite reasonable net debt to EBITDA multiple of 2.2, its interest cover seems weak, at 2.2. This does have us wondering if the company pays high interest because it is considered risky. In any case, it's safe to say the company has meaningful debt. Pleasingly, DATA Communications Management is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 348% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since DATA Communications Management will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, DATA Communications Management actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

DATA Communications Management's conversion of EBIT to free cash flow was a real positive on this analysis, as was its EBIT growth rate. In contrast, our confidence was undermined by its apparent struggle to cover its interest expense with its EBIT. When we consider all the factors mentioned above, we do feel a bit cautious about DATA Communications Management's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 5 warning signs for DATA Communications Management you should be aware of, and 1 of them is a bit unpleasant.

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. 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.
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