Yahoo Finance Devro (LON:DVO) Takes On Some Risk With Its Use Of Debt
Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Devro plc (LON:DVO) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
View our latest analysis for Devro
What Is Devro's Net Debt?
As you can see below, Devro had UK£162.2m of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it does have UK£14.0m in cash offsetting this, leading to net debt of about UK£148.2m.
How Healthy Is Devro's Balance Sheet?
According to the last reported balance sheet, Devro had liabilities of UK£32.8m due within 12 months, and liabilities of UK£244.0m due beyond 12 months. On the other hand, it had cash of UK£14.0m and UK£35.1m worth of receivables due within a year. So it has liabilities totalling UK£227.7m more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of UK£331.1m, so it does suggest shareholders should keep an eye on Devro's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Devro's net debt is sitting at a very reasonable 2.4 times its EBITDA, while its EBIT covered its interest expense just 6.4 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. We saw Devro grow its EBIT by 7.1% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Devro can strengthen its balance sheet over time. 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. Looking at the most recent three years, Devro recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Our View
Both Devro's level of total liabilities and its net debt to EBITDA were discouraging. At least its EBIT growth rate gives us reason to be optimistic. Looking at all the angles mentioned above, it does seem to us that Devro is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. Given our hesitation about the stock, it would be good to know if Devro insiders have sold any shares recently. You click here to find out if insiders have sold recently.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.
