Is Dynamatic Technologies (NSE:DYNAMATECH) A Risky Investment?

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Dynamatic Technologies Limited (NSE:DYNAMATECH) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Dynamatic Technologies

What Is Dynamatic Technologies's Net Debt?

As you can see below, Dynamatic Technologies had ₹5.42b of debt at September 2020, down from ₹6.05b a year prior. However, because it has a cash reserve of ₹567.7m, its net debt is less, at about ₹4.85b.

How Strong Is Dynamatic Technologies' Balance Sheet?

We can see from the most recent balance sheet that Dynamatic Technologies had liabilities of ₹5.70b falling due within a year, and liabilities of ₹4.54b due beyond that. On the other hand, it had cash of ₹567.7m and ₹1.90b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹7.77b.

Given this deficit is actually higher than the company's market capitalization of ₹5.29b, we think shareholders really should watch Dynamatic Technologies's debt levels, like a parent watching their child ride a bike for the first time. 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.

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). 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).

While Dynamatic Technologies's debt to EBITDA ratio (4.8) suggests that it uses some debt, its interest cover is very weak, at 0.77, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Worse, Dynamatic Technologies's EBIT was down 55% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Dynamatic Technologies will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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. Over the last three years, Dynamatic Technologies recorded free cash flow worth a fulsome 95% 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

On the face of it, Dynamatic Technologies's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. We're quite clear that we consider Dynamatic Technologies to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Dynamatic Technologies you should be aware of, and 1 of them is concerning.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. 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.
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