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 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. Importantly, Ducommun Incorporated (NYSE:DCO) does carry debt. But should shareholders be worried about its use of debt?
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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Ducommun Carry?
The chart below, which you can click on for greater detail, shows that Ducommun had US$318.9m in debt in December 2020; about the same as the year before. However, because it has a cash reserve of US$56.5m, its net debt is less, at about US$262.5m.
How Strong Is Ducommun's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Ducommun had liabilities of US$142.9m due within 12 months and liabilities of US$365.1m due beyond that. Offsetting this, it had US$56.5m in cash and US$212.1m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$239.5m.
This deficit isn't so bad because Ducommun is worth US$750.9m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
Ducommun's debt is 3.4 times its EBITDA, and its EBIT cover its interest expense 3.5 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Investors should also be troubled by the fact that Ducommun saw its EBIT drop by 18% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Ducommun can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Ducommun recorded free cash flow of 42% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Mulling over Ducommun's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But at least its level of total liabilities is not so bad. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Ducommun stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. We've identified 1 warning sign with Ducommun , and understanding them should be part of your investment process.
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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What are the risks and opportunities for Ducommun?
Trading at 25.6% below our estimate of its fair value
Earnings are forecast to grow 2.88% per year
Earnings grew by 283.3% over the past year
Debt is not well covered by operating cash flow
High level of non-cash earnings
Significant insider selling over the past 3 months
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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