Dis-Chem Pharmacies (JSE:DCP) Seems To Use Debt Quite Sensibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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, Dis-Chem Pharmacies Limited (JSE:DCP) does carry debt. But the real question is whether this debt is making the company risky.

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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Dis-Chem Pharmacies

What Is Dis-Chem Pharmacies's Net Debt?

The image below, which you can click on for greater detail, shows that at August 2023 Dis-Chem Pharmacies had debt of R1.96b, up from R1.86b in one year. However, because it has a cash reserve of R788.9m, its net debt is less, at about R1.17b.

How Healthy Is Dis-Chem Pharmacies' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Dis-Chem Pharmacies had liabilities of R8.95b due within 12 months and liabilities of R3.42b due beyond that. Offsetting these obligations, it had cash of R788.9m as well as receivables valued at R2.83b due within 12 months. So it has liabilities totalling R8.76b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Dis-Chem Pharmacies is worth R26.0b, 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 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Dis-Chem Pharmacies's low debt to EBITDA ratio of 0.56 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.2 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Notably Dis-Chem Pharmacies's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Dis-Chem Pharmacies'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Dis-Chem Pharmacies produced sturdy free cash flow equating to 68% 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.

Our View

Dis-Chem Pharmacies's net debt to EBITDA was a real positive on this analysis, as was its conversion of EBIT to free cash flow. On the other hand, its interest cover makes us a little less comfortable about its debt. Considering this range of data points, we think Dis-Chem Pharmacies is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. To that end, you should be aware of the 1 warning sign we've spotted with Dis-Chem Pharmacies .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.