These 4 Measures Indicate That DFCITY Group Berhad (KLSE:DFCITY) Is Using Debt Extensively

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 DFCITY Group Berhad (KLSE:DFCITY) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for DFCITY Group Berhad

How Much Debt Does DFCITY Group Berhad Carry?

You can click the graphic below for the historical numbers, but it shows that DFCITY Group Berhad had RM32.2m of debt in December 2020, down from RM34.2m, one year before. On the flip side, it has RM2.91m in cash leading to net debt of about RM29.3m.

How Strong Is DFCITY Group Berhad's Balance Sheet?

We can see from the most recent balance sheet that DFCITY Group Berhad had liabilities of RM22.9m falling due within a year, and liabilities of RM20.3m due beyond that. Offsetting these obligations, it had cash of RM2.91m as well as receivables valued at RM5.06m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by RM35.2m.

This deficit is considerable relative to its market capitalization of RM47.5m, so it does suggest shareholders should keep an eye on DFCITY Group Berhad's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

DFCITY Group Berhad shareholders face the double whammy of a high net debt to EBITDA ratio (14.2), and fairly weak interest coverage, since EBIT is just 0.41 times the interest expense. This means we'd consider it to have a heavy debt load. However, the silver lining was that DFCITY Group Berhad achieved a positive EBIT of RM773k in the last twelve months, an improvement on the prior year's loss. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since DFCITY Group Berhad 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, DFCITY Group Berhad actually produced more free cash flow than EBIT over the last year. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

DFCITY Group Berhad's interest cover and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. When we consider all the factors discussed, it seems to us that DFCITY Group Berhad is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for DFCITY Group Berhad (1 is a bit concerning) you should be aware of.

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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