Stock Analysis

DXC Technology (NYSE:DXC) Has A Somewhat Strained Balance Sheet

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NYSE:DXC
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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, DXC Technology Company (NYSE:DXC) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

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What Is DXC Technology's Debt?

The image below, which you can click on for greater detail, shows that DXC Technology had debt of US$4.27b at the end of December 2021, a reduction from US$5.26b over a year. On the flip side, it has US$2.92b in cash leading to net debt of about US$1.35b.

debt-equity-history-analysis
NYSE:DXC Debt to Equity History March 27th 2022

How Healthy Is DXC Technology's Balance Sheet?

We can see from the most recent balance sheet that DXC Technology had liabilities of US$6.73b falling due within a year, and liabilities of US$8.14b due beyond that. Offsetting this, it had US$2.92b in cash and US$3.67b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$8.28b.

Given this deficit is actually higher than the company's market capitalization of US$8.20b, we think shareholders really should watch DXC Technology's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). 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 0.70 times EBITDA, it is initially surprising to see that DXC Technology's EBIT has low interest coverage of 2.2 times. So while we're not necessarily alarmed we think that its debt is far from trivial. Shareholders should be aware that DXC Technology's EBIT was down 52% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, DXC Technology generated free cash flow amounting to a very robust 96% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

To be frank both DXC Technology's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that DXC Technology's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for DXC Technology you should know about.

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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