Is Diagnostic Medical Systems (EPA:ALDMS) Using Debt In A Risky Way?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Diagnostic Medical Systems S.A. (EPA:ALDMS) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

Check out our latest analysis for Diagnostic Medical Systems

What Is Diagnostic Medical Systems's Net Debt?

As you can see below, at the end of December 2021, Diagnostic Medical Systems had €10.4m of debt, up from €8.85m a year ago. Click the image for more detail. However, because it has a cash reserve of €4.20m, its net debt is less, at about €6.15m.

How Healthy Is Diagnostic Medical Systems' Balance Sheet?

The latest balance sheet data shows that Diagnostic Medical Systems had liabilities of €21.7m due within a year, and liabilities of €10.9m falling due after that. On the other hand, it had cash of €4.20m and €10.4m worth of receivables due within a year. So its liabilities total €18.0m more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's €14.8m 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. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Diagnostic Medical Systems 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.

Over 12 months, Diagnostic Medical Systems reported revenue of €40m, which is a gain of 14%, although it did not report any earnings before interest and tax. That rate of growth is a bit slow for our taste, but it takes all types to make a world.

Caveat Emptor

Over the last twelve months Diagnostic Medical Systems produced an earnings before interest and tax (EBIT) loss. Indeed, it lost €905k at the EBIT level. When we look at that alongside the significant liabilities, we're not particularly confident about the company. We'd want to see some strong near-term improvements before getting too interested in the stock. Not least because it had negative free cash flow of €7.0m over the last twelve months. That means it's on the risky side of things. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for Diagnostic Medical Systems you should be aware of, and 2 of them don't sit too well with us.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.