Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from risk.” So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. We notice that Delta Manufacture Limited (NSE: DELTAMAGNT) has debt on its balance sheet. But should shareholders be concerned about its use of debt?
What risk does debt entail?
Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. If things really go wrong, lenders can take over the business. However, a more common (but still painful) scenario is that he has to raise new equity at low cost, thereby constantly diluting shareholders. 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.
Check out our latest analysis for Delta Manufacturing
What is Delta Manufacturing’s debt?
The image below, which you can click for more details, shows that Delta Manufacturing had a debt of 472.8 million yen at the end of September 2021, a reduction of 495.7 million yen on a year. However, it has 89.3 million euros in cash offsetting this, which leads to net debt of around 383.5 million euros.
A look at the responsibilities of Delta Manufacturing
The latest balance sheet data shows that Delta Manufacturing had liabilities of 686.0 million yen due within one year, and liabilities of 90.6 million yen due after that. On the other hand, it had cash of 89.3 M and 334.2 M of receivables due within one year. Thus, its liabilities exceed the sum of its cash and its (short-term) receivables by 353.2 million euros.
While that might sound like a lot, it’s not so bad since Delta Manufacturing has a market capitalization of 1.15 billion yen, and therefore could likely strengthen its balance sheet by raising capital if needed. But it is clear that it is absolutely necessary to take a close look at whether it can manage its debt without dilution.
We measure a company’s indebtedness relative to its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating the ease with which its earnings before interest and taxes (EBIT ) covers its interests. 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 Delta Manufacturing’s 4.7 net debt to EBITDA ratio, we do think its ultra-low 0.73 times interest coverage is a sign of high leverage. In large part, this is due to the company’s large depreciation and amortization charges, which arguably means that its EBITDA is a very generous measure of profit, and its debt may be heavier than it appears. At first glance. It seems clear that the cost of borrowing money is having a negative impact on shareholder returns lately. However, the bright side is that Delta Manufacturing achieved a positive EBIT of 39 million euros over the past twelve months, an improvement over the loss of the previous year. There is no doubt that we learn the most about debt from the balance sheet. But you can’t look at debt in isolation; since Delta Manufacturing will need revenue to repay this debt. So, when considering debt, it is really worth looking at the profit trend. Click here for an interactive snapshot.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. It is therefore important to check to what extent its earnings before interest and taxes (EBIT) are converted into actual free cash flow. Over the past year, Delta Manufacturing has reported free cash flow of 9.6% of its EBIT, which is really pretty low. This low level of cash conversion undermines its ability to manage and repay its debts.
Our point of view
We would go so far as to say that Delta Manufacturing’s interest coverage was disappointing. That said, his ability to increase his EBIT is not that much of a concern. Once we consider all of the above factors together, it seems like Delta Manufacturing’s debt makes it a bit risky. This isn’t necessarily a bad thing, but we would generally feel more comfortable with less leverage. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, Delta Manufacturing has 4 warning signs (and 2 which don’t suit us very well) we think you should be aware of.
If, after all of this, you’re more interested in a fast-growing company with a strong balance sheet, take a quick look at our list of cash-flow net-growth stocks.
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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 any stock 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 documents. Simply Wall St has no position in any of the stocks mentioned.