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.” When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. We can see that PLC Diploma (LON: DPLM) uses debt in its business. But does this debt worry shareholders?
When is Debt a Problem?
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. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
Check out our latest analysis for the diploma
How much debt does the diploma carry?
You can click on the graph below for historical figures, but it shows that as of September 2021, Diploma was in debt of £ 206.2million, an increase from none, year over year. However, he also had £ 24.8million in cash, so his net debt is £ 181.4million.
A look at the responsibilities of the diploma
According to the latest published balance sheet, Diploma had liabilities of £ 176.4million due within 12 months and liabilities of £ 266.0million due beyond 12 months. In compensation for these obligations, it had cash of £ 24.8 million as well as receivables valued at £ 112.8 million maturing within 12 months. It therefore has liabilities totaling £ 304.8million more than its cash and short-term receivables combined.
Given that the listed Diploma shares are worth a total of £ 3.99bn, it seems unlikely that this level of liabilities is a major threat. Having said that, it is clear that we must continue to monitor his record lest it get worse.
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.
Diploma has a low net debt to EBITDA ratio of just 1.3. And its EBIT easily covers its interest costs, being 17.2 times higher. We could therefore say that he is no more threatened by his debt than an elephant is by a mouse. On top of that, Diploma has increased its EBIT by 62% over the past twelve months, and this growth will make it easier to process its debt. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Diploma can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Over the past three years, Diploma has generated free cash flow amounting to a very solid 91% of its EBIT, more than we expected. This positions it well to repay debt if it is desirable.
Our point of view
Fortunately, Diploma’s impressive interest coverage means it has the upper hand on its debt. And the good news does not end there, since its conversion of EBIT into free cash flow also confirms this impression! Considering this range of factors, it seems to us that Diploma is fairly cautious with its debt, and the risks appear to be well under control. The balance sheet therefore seems rather healthy to us. On top of most other metrics, we think it’s important to track how quickly earnings per share are growing, if at all. If you have understood this as well, you are in luck because today you can view this interactive graph of historical earnings per share of Diploma for free.
If you want to invest in companies that can generate profits without the burden of debt, check out this free list of growing companies that have net cash on the balance sheet.
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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.