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. Importantly, DWF Group plc (LON:DWF) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does DWF Group Carry?
You can click the graphic below for the historical numbers, but it shows that DWF Group had UK£48.2m of debt in April 2019, down from UK£59.2m, one year before. However, it does have UK£12.9m in cash offsetting this, leading to net debt of about UK£35.3m.
How Strong Is DWF Group's Balance Sheet?
According to the last reported balance sheet, DWF Group had liabilities of UK£104.4m due within 12 months, and liabilities of UK£50.8m due beyond 12 months. On the other hand, it had cash of UK£12.9m and UK£152.3m worth of receivables due within a year. So it actually has UK£9.98m more liquid assets than total liabilities.
This short term liquidity is a sign that DWF Group could probably pay off its debt with ease, as its balance sheet is far from stretched.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
DWF Group has a low net debt to EBITDA ratio of only 1.1. And its EBIT covers its interest expense a whopping 25.9 times over. So we're pretty relaxed about its super-conservative use of 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 DWF Group'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.
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. During the last three years, DWF Group burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
The good news is DWF seems to be able to cover its interest expense with its EBIT with ease. While that debt can boost returns, we think the company has enough leverage now. Over time, share prices tend to follow earnings per share, so if you're interested in DWF Group, you may well want to click here to check an interactive graph of its earnings per share history.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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