Here's Why DFDS (CPH:DFDS) Can Manage Its Debt Responsibly

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 note that DFDS A/S (CPH:DFDS) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 DFDS

How Much Debt Does DFDS Carry?

As you can see below, DFDS had kr.10.8b of debt, at December 2022, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has kr.1.19b in cash leading to net debt of about kr.9.64b.

A Look At DFDS' Liabilities

According to the last reported balance sheet, DFDS had liabilities of kr.8.05b due within 12 months, and liabilities of kr.12.9b due beyond 12 months. On the other hand, it had cash of kr.1.19b and kr.4.02b worth of receivables due within a year. So its liabilities total kr.15.7b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's kr.15.0b market capitalization, you might well be inclined to review the balance sheet intently. 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.

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). 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).

DFDS's net debt is sitting at a very reasonable 2.5 times its EBITDA, while its EBIT covered its interest expense just 6.9 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Importantly, DFDS grew its EBIT by 93% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if DFDS 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, DFDS recorded free cash flow worth a fulsome 91% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

DFDS's conversion of EBIT to free cash flow was a real positive on this analysis, as was its EBIT growth rate. On the other hand, its level of total liabilities makes us a little less comfortable about its debt. Considering this range of data points, we think DFDS is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. Be aware that DFDS is showing 2 warning signs in our investment analysis , you should know about...

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. 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.