DATAGROUP (ETR:D6H) Takes On Some Risk With Its Use Of Debt

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. We can see that DATAGROUP SE (ETR:D6H) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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.

Check out our latest analysis for DATAGROUP

How Much Debt Does DATAGROUP Carry?

As you can see below, DATAGROUP had €87.3m of debt at March 2021, down from €141.6m a year prior. However, it also had €73.5m in cash, and so its net debt is €13.8m.

A Look At DATAGROUP's Liabilities

Zooming in on the latest balance sheet data, we can see that DATAGROUP had liabilities of €105.7m due within 12 months and liabilities of €196.6m due beyond that. Offsetting this, it had €73.5m in cash and €60.5m in receivables that were due within 12 months. So its liabilities total €168.3m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because DATAGROUP is worth €552.4m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With net debt sitting at just 0.37 times EBITDA, DATAGROUP is arguably pretty conservatively geared. And it boasts interest cover of 7.4 times, which is more than adequate. It is just as well that DATAGROUP's load is not too heavy, because its EBIT was down 36% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if DATAGROUP can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept 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, DATAGROUP reported free cash flow worth 19% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

DATAGROUP's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. In particular, its net debt to EBITDA was re-invigorating. When we consider all the factors discussed, it seems to us that DATAGROUP is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with DATAGROUP .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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