Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that DXC Technology Company (NYSE:DXC) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 think about a company's use of debt, we first look at cash and debt together.
What Is DXC Technology's Net Debt?
The image below, which you can click on for greater detail, shows that DXC Technology had debt of US$4.32b at the end of March 2022, a reduction from US$4.62b over a year. However, because it has a cash reserve of US$2.67b, its net debt is less, at about US$1.65b.
A Look At DXC Technology's Liabilities
We can see from the most recent balance sheet that DXC Technology had liabilities of US$6.85b falling due within a year, and liabilities of US$7.91b due beyond that. Offsetting this, it had US$2.67b in cash and US$3.85b in receivables that were due within 12 months. So it has liabilities totalling US$8.24b more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of US$6.88b, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
DXC Technology has a low net debt to EBITDA ratio of only 0.54. And its EBIT covers its interest expense a whopping 11.1 times over. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that DXC Technology grew its EBIT by 7,645% over twelve months. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine DXC Technology's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, DXC Technology produced sturdy free cash flow equating to 80% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, DXC Technology's impressive EBIT growth rate implies it has the upper hand on its debt. But the stark truth is that we are concerned by its level of total liabilities. All these things considered, it appears that DXC Technology can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with DXC Technology (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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.
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