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.' 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. As with many other companies Ducommun Incorporated (NYSE:DCO) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Ducommun's Net Debt?
As you can see below, at the end of March 2019, Ducommun had US$231.5m of debt, up from US$209.7m a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.
How Healthy Is Ducommun's Balance Sheet?
We can see from the most recent balance sheet that Ducommun had liabilities of US$117.7m falling due within a year, and liabilities of US$279.3m due beyond that. Offsetting this, it had US$3.83m in cash and US$156.4m in receivables that were due within 12 months. So it has liabilities totalling US$236.7m more than its cash and near-term receivables, combined.
This deficit isn't so bad because Ducommun is worth US$500.5m, 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 use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Ducommun has a debt to EBITDA ratio of 3.2 and its EBIT covered its interest expense 3.1 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. The good news is that Ducommun grew its EBIT a smooth 62% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Ducommun's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Ducommun recorded free cash flow worth 55% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
On our analysis Ducommun's EBIT growth rate should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to cover its interest expense with its EBIT. When we consider all the elements mentioned above, it seems to us that Ducommun 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 Ducommun 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.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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