Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say this when he says “The biggest risk in investing is not price volatility, but if you will suffer a loss. permanent capital “. So it can be obvious that you need to consider debt, when you think about how risky a given stock is, because too much debt can sink a business. Above all, DS Smith Plc (LON: SMDS) carries the debt. But the real question is whether this debt makes the business risky.
When is Debt a Problem?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. That said, the most common situation is where a business manages its debt reasonably well – and to its own advantage. When we look at debt levels, we first look at cash and debt levels, together.
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What is DS Smith’s debt?
The image below, which you can click for more details, shows that DS Smith was in debt of Â£ 2.22bn at the end of October 2021, a reduction from Â£ 2.41bn. pounds sterling over one year. However, he has Â£ 744.0million in cash offsetting this, leading to net debt of around Â£ 1.48 billion.
How strong is DS Smith’s balance sheet?
Zooming in on the latest balance sheet data, we can see that DS Smith had a liability of Â£ 3.18bn due within 12 months and a liability of Â£ 2.03bn beyond. On the other hand, he had cash of Â£ 744.0million and a value of Â£ 1.06 billion of receivables due within one year. Its liabilities therefore total Â£ 3.41 billion more than the combination of its cash and short-term receivables.
This shortfall is sizable compared to its market cap of Â£ 5.34 billion, so he suggests shareholders keep an eye on DS Smith’s use of debt. If its lenders asked it to consolidate the balance sheet, shareholders would likely face severe dilution.
In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
DS Smith’s net debt stands at a very reasonable level of 2.0 times its EBITDA, while its EBIT only covered its interest expense 6.6 times last year. While we’re not worried about these numbers, it’s worth noting that the company’s cost of debt does have a real impact. DS Smith has increased its EBIT by 2.6% over the past year. It’s far from incredible, but it’s a good thing when it comes to paying down debt. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine DS Smith’s ability to maintain a healthy balance sheet going forward. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. Over the past three years, DS Smith has recorded free cash flow of 68% of its EBIT, which is close to normal given that free cash flow excludes interest and taxes. This free cash flow puts the business in a good position to repay debt, if any.
Our point of view
Based on our analysis, converting DS Smith’s EBIT to free cash flow should indicate that it will not have too many problems with its debt. However, our other observations were not so encouraging. For example, his total liability level makes us a little nervous about his debt. Looking at all of this data, we feel a little cautious about DS Smith’s debt levels. While we understand that debt can improve returns on equity, we suggest shareholders watch their debt level closely, lest they increase. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks lie on the balance sheet – far from it. To this end, you need to know the 1 warning sign we spotted with DS Smith.
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
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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.