Stock Analysis

Delegat Group (NZSE:DGL) Takes On Some Risk With Its Use Of Debt

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NZSE:DGL

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.' 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. As with many other companies Delegat Group Limited (NZSE:DGL) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Delegat Group

How Much Debt Does Delegat Group Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2023 Delegat Group had NZ$357.6m of debt, an increase on NZ$313.9m, over one year. And it doesn't have much cash, so its net debt is about the same.

NZSE:DGL Debt to Equity History June 19th 2024

How Strong Is Delegat Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Delegat Group had liabilities of NZ$59.1m due within 12 months and liabilities of NZ$490.3m due beyond that. Offsetting this, it had NZ$5.30m in cash and NZ$86.0m in receivables that were due within 12 months. So it has liabilities totalling NZ$458.1m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of NZ$508.7m, so it does suggest shareholders should keep an eye on Delegat Group's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Delegat Group's debt is 3.1 times its EBITDA, and its EBIT cover its interest expense 5.6 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Sadly, Delegat Group's EBIT actually dropped 5.2% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Delegat Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Delegat Group created free cash flow amounting to 6.1% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On the face of it, Delegat Group's level of total liabilities left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. Looking at the bigger picture, it seems clear to us that Delegat Group's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. Be aware that Delegat Group is showing 2 warning signs in our investment analysis , and 1 of those is a bit concerning...

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.