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. Importantly, DXC Technology Company (NYSE:DXC) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is DXC Technology's Net Debt?
You can click the graphic below for the historical numbers, but it shows that DXC Technology had US$4.62b of debt in March 2021, down from US$8.89b, one year before. However, it also had US$2.97b in cash, and so its net debt is US$1.65b.
How Strong Is DXC Technology's Balance Sheet?
According to the last reported balance sheet, DXC Technology had liabilities of US$8.15b due within 12 months, and liabilities of US$8.58b due beyond 12 months. Offsetting this, it had US$2.97b in cash and US$4.16b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$9.61b.
This deficit is considerable relative to its very significant market capitalization of US$10.2b, so it does suggest shareholders should keep an eye on DXC Technology'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). 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).
Given net debt is only 0.93 times EBITDA, it is initially surprising to see that DXC Technology's EBIT has low interest coverage of 0.20 times. So while we're not necessarily alarmed we think that its debt is far from trivial. Importantly, DXC Technology's EBIT fell a jaw-dropping 97% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 DXC Technology 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.
Finally, while the tax-man may adore accounting profits, lenders only accept 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 most recent three years, DXC Technology recorded free cash flow worth 69% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
On the face of it, DXC Technology'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. Overall, we think it's fair to say that DXC Technology has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Given our hesitation about the stock, it would be good to know if DXC Technology insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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