The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Diplomat Pharmacy, Inc. (NYSE:DPLO) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Diplomat Pharmacy's Net Debt?
The chart below, which you can click on for greater detail, shows that Diplomat Pharmacy had US$580.3m in debt in June 2019; about the same as the year before. And it doesn't have much cash, so its net debt is about the same.
How Healthy Is Diplomat Pharmacy's Balance Sheet?
We can see from the most recent balance sheet that Diplomat Pharmacy had liabilities of US$545.3m falling due within a year, and liabilities of US$470.4m due beyond that. On the other hand, it had cash of US$5.77m and US$343.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$666.2m.
The deficiency here weighs heavily on the US$439.4m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt After all, Diplomat Pharmacy would likely require a major re-capitalisation if it had to pay its creditors today.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 0.37 times and a disturbingly high net debt to EBITDA ratio of 6.9 hit our confidence in Diplomat Pharmacy like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, Diplomat Pharmacy saw its EBIT tank 45% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Diplomat Pharmacy'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Diplomat Pharmacy actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
On the face of it, Diplomat Pharmacy's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. We should also note that Healthcare industry companies like Diplomat Pharmacy commonly do use debt without problems. We're quite clear that we consider Diplomat Pharmacy to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. Given our concerns about Diplomat Pharmacy's debt levels, it seems only prudent to check if insiders have been ditching the stock.
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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