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 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. We can see that DXP Enterprises, Inc. (NASDAQ:DXPE) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is DXP Enterprises's Net Debt?
The chart below, which you can click on for greater detail, shows that DXP Enterprises had US$239.6m in debt in June 2019; about the same as the year before. On the flip side, it has US$25.4m in cash leading to net debt of about US$214.2m.
How Strong Is DXP Enterprises's Balance Sheet?
We can see from the most recent balance sheet that DXP Enterprises had liabilities of US$158.3m falling due within a year, and liabilities of US$298.1m due beyond that. On the other hand, it had cash of US$25.4m and US$246.3m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$184.6m.
This deficit isn't so bad because DXP Enterprises is worth US$642.8m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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). 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).
DXP Enterprises's net debt is sitting at a very reasonable 2.1 times its EBITDA, while its EBIT covered its interest expense just 3.8 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. It is well worth noting that DXP Enterprises's EBIT shot up like bamboo after rain, gaining 62% in the last twelve months. That'll make it easier to manage its 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 DXP Enterprises'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. In the last three years, DXP Enterprises's free cash flow amounted to 39% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
When it comes to the balance sheet, the standout positive for DXP Enterprises was the fact that it seems able to grow its EBIT confidently. However, our other observations weren't so heartening. For example, its interest cover makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that DXP Enterprises is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. We'd be motivated to research the stock further if we found out that DXP Enterprises insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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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