Here's Why discoverIE Group (LON:DSCV) Can Manage Its Debt Responsibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that discoverIE Group plc (LON:DSCV) 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 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 discoverIE Group

How Much Debt Does discoverIE Group Carry?

As you can see below, at the end of September 2023, discoverIE Group had UK£234.0m of debt, up from UK£79.4m a year ago. Click the image for more detail. On the flip side, it has UK£122.7m in cash leading to net debt of about UK£111.3m.

How Healthy Is discoverIE Group's Balance Sheet?

We can see from the most recent balance sheet that discoverIE Group had liabilities of UK£197.3m falling due within a year, and liabilities of UK£188.4m due beyond that. Offsetting these obligations, it had cash of UK£122.7m as well as receivables valued at UK£82.3m due within 12 months. So its liabilities total UK£180.7m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since discoverIE Group has a market capitalization of UK£684.7m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

discoverIE Group's net debt of 1.8 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 7.2 times its interest expenses harmonizes with that theme. Also relevant is that discoverIE Group has grown its EBIT by a very respectable 22% in the last year, thus enhancing its ability to pay down 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 discoverIE Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, discoverIE Group recorded free cash flow worth a fulsome 83% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

The good news is that discoverIE Group's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Looking at the bigger picture, we think discoverIE Group's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. We'd be motivated to research the stock further if we found out that discoverIE Group insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.

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.