Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital”. So it can be obvious that you need to consider debt, when you think about how risky a given stock is, because too much debt can sink a business. Above all, DATA Communications Management Corp. (TSE: DCM) is in debt. But the real question is whether this debt makes the business risky.
When Is Debt a Problem?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still painful) scenario is that he must raise new equity at low cost, thereby diluting shareholders over the long term. Of course, many companies use debt to finance their growth without negative consequences. When we think of a business’s use of debt, we first look at cash flow and debt together.
See our latest analysis for DATA Communications Management
What is DATA Communications Management’s debt?
You can click on the graph below for historical figures, but it shows DATA Communications Management had CA $ 38.6 million in debt in June 2021, up from CA $ 74.0 million a year earlier. Net debt is about the same because it doesn’t have a lot of cash.
How strong is DATA Communications Management’s balance sheet?
Zooming in on the latest balance sheet data, we can see that DATA Communications Management had a liability of CA $ 56.6 million due within 12 months and a liability of CA $ 79.2 million beyond. On the other hand, he had CA $ 163.0k in cash and CA $ 56.1 million in receivables due within one year. As a result, its liabilities exceed the sum of its cash and (short-term) receivables by C $ 79.5 million.
When you consider that this deficit exceeds the company’s C $ 55.1 million market capitalization, you may well be inclined to take a close look at the balance sheet. Hypothetically, extremely high dilution would be required if the company were forced to repay its debts by raising capital at the current share price.
We measure a company’s debt load relative to its earning capacity by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT) covers its interest costs (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
While we’re not worried about DATA Communications Management’s net debt to EBITDA ratio of 2.7, we believe its ultra-low 1.7 times interest coverage is a sign of high leverage. Shareholders should therefore probably be aware that interest charges seem to have had a real impact on the company in recent times. The good news is that DATA Communications Management has increased its EBIT by 40% over the past twelve months. Like a mother’s loving embrace of a newborn, this type of growth builds resilience, putting the business in a stronger position to manage debt. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether DATA Communications Management can strengthen its balance sheet over time. So, if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. We must therefore clearly check whether this EBIT generates a corresponding free cash flow. Fortunately for all shareholders, DATA Communications Management has actually generated more free cash flow than EBIT over the past three years. This kind of solid money conversion makes us as excited as the crowd when the beat drops at a Daft Punk concert.
Our point of view
Whereas the coverage of DATA Communications Management’s interests makes us nervous. Its conversion of EBIT to free cash flow and the growth rate of EBIT were encouraging signs. We think DATA Communications Management’s debt makes it a bit risky, having considered the aforementioned data points together. This isn’t necessarily a bad thing, as leverage can increase returns on equity, but it’s something to be aware of. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. We have identified 4 warning signs with DATA Communications Management (at least 1 which is not too good for us), and understanding them should be part of your investment process.
If you are interested in investing in companies that can generate profits without the burden of debt, check out this page free list of growing companies that have net cash on the balance sheet.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in any of the stocks mentioned.
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