Is Demant (CPH:DEMANT) Using Too Much 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.' 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 Demant A/S (CPH:DEMANT) makes use of debt. But the real question is whether this debt is making the company risky.

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 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Demant

What Is Demant's Net Debt?

As you can see below, at the end of June 2023, Demant had kr.11.9b of debt, up from kr.11.3b a year ago. Click the image for more detail. However, because it has a cash reserve of kr.1.16b, its net debt is less, at about kr.10.8b.

A Look At Demant's Liabilities

According to the last reported balance sheet, Demant had liabilities of kr.9.26b due within 12 months, and liabilities of kr.11.6b due beyond 12 months. Offsetting this, it had kr.1.16b in cash and kr.4.76b in receivables that were due within 12 months. So it has liabilities totalling kr.14.9b more than its cash and near-term receivables, combined.

Demant has a market capitalization of kr.59.9b, so it could very likely raise cash to ameliorate 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.

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

With net debt to EBITDA of 2.6 Demant has a fairly noticeable amount of debt. On the plus side, its EBIT was 8.8 times its interest expense, and its net debt to EBITDA, was quite high, at 2.6. Demant grew its EBIT by 6.6% in the last year. That's far from incredible but it is a good thing, when it comes to paying off 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 Demant'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.

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. During the last three years, Demant produced sturdy free cash flow equating to 72% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, Demant's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But truth be told we feel its net debt to EBITDA does undermine this impression a bit. It's also worth noting that Demant is in the Medical Equipment industry, which is often considered to be quite defensive. When we consider the range of factors above, it looks like Demant is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for Demant that you should be aware of before investing here.

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.