Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Danaos Corporation (NYSE:DAC) makes use of debt. But the more important question is: how much risk is that debt creating?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Danaos Carry?
The image below, which you can click on for greater detail, shows that at March 2021 Danaos had debt of US$1.57b, up from US$1.37b in one year. However, it also had US$68.1m in cash, and so its net debt is US$1.50b.
How Healthy Is Danaos' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Danaos had liabilities of US$190.6m due within 12 months and liabilities of US$1.71b due beyond that. On the other hand, it had cash of US$68.1m and US$7.34m worth of receivables due within a year. So its liabilities total US$1.82b more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's US$1.51b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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.
Danaos has a debt to EBITDA ratio of 4.7 and its EBIT covered its interest expense 4.4 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. On a slightly more positive note, Danaos grew its EBIT at 10% over the last year, further increasing its ability to manage debt. 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 Danaos 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Danaos recorded free cash flow worth a fulsome 82% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
Danaos's level of total liabilities and net debt to EBITDA definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. We think that Danaos's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Be aware that Danaos is showing 5 warning signs in our investment analysis , and 2 of those are significant...
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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