These 4 Measures Indicate That DIT Group (HKG:726) Is Using Debt Extensively

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. Importantly, DIT Group Limited (HKG:726) does carry debt. But should shareholders be worried about its use of debt?

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. 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for DIT Group

What Is DIT Group's Net Debt?

As you can see below, at the end of December 2021, DIT Group had HK$2.18b of debt, up from HK$1.46b a year ago. Click the image for more detail. However, because it has a cash reserve of HK$490.9m, its net debt is less, at about HK$1.69b.

How Strong Is DIT Group's Balance Sheet?

We can see from the most recent balance sheet that DIT Group had liabilities of HK$2.74b falling due within a year, and liabilities of HK$1.46b due beyond that. On the other hand, it had cash of HK$490.9m and HK$2.14b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$1.56b.

This deficit is considerable relative to its market capitalization of HK$1.80b, so it does suggest shareholders should keep an eye on DIT Group's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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

With a net debt to EBITDA ratio of 5.5, it's fair to say DIT Group does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 5.7 times, suggesting it can responsibly service its obligations. Notably DIT Group's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since DIT Group 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, DIT Group burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both DIT Group's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its interest cover is not so bad. We're quite clear that we consider DIT Group to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. Be aware that DIT Group is showing 4 warning signs in our investment analysis , and 1 of those is a bit concerning...

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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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.