These 4 Measures Indicate That Dynamatic Technologies (NSE:DYNAMATECH) Is Using Debt Extensively

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Dynamatic Technologies Limited (NSE:DYNAMATECH) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out 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, it also had ₹567.7m in cash, and so its net debt is ₹4.85b.

How Strong Is Dynamatic Technologies's Balance Sheet?

According to the last reported balance sheet, Dynamatic Technologies had liabilities of ₹5.70b due within 12 months, and liabilities of ₹4.54b due beyond 12 months. Offsetting this, it had ₹567.7m in cash and ₹1.90b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹7.77b.

The deficiency here weighs heavily on the ₹4.51b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Dynamatic Technologies would probably need a major re-capitalization if its creditors were to demand repayment.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 0.71 times and a disturbingly high net debt to EBITDA ratio of 6.3 hit our confidence in Dynamatic Technologies like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, Dynamatic Technologies's EBIT was down 59% 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 it is Dynamatic Technologies's earnings that will influence how the balance sheet holds up in the future. 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 we always check how much of that EBIT is translated into free cash flow. During the last three years, Dynamatic Technologies generated free cash flow amounting to a very robust 98% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

On the face of it, Dynamatic Technologies's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Taking into account all the aforementioned factors, it looks like Dynamatic Technologies has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Dynamatic Technologies you should be aware of, and 1 of them shouldn't be ignored.

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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