Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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. Importantly, Dana Incorporated (NYSE:DAN) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Dana’s Debt?
You can click the graphic below for the historical numbers, but it shows that Dana had US$2.47b of debt in September 2021, down from US$2.96b, one year before. However, it does have US$238.0m in cash offsetting this, leading to net debt of about US$2.23b.
How Strong Is Dana’s Balance Sheet?
According to the last reported balance sheet, Dana had liabilities of US$2.17b due within 12 months, and liabilities of US$3.30b due beyond 12 months. Offsetting these obligations, it had cash of US$238.0m as well as receivables valued at US$1.64b due within 12 months. So it has liabilities totalling US$3.59b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company’s US$3.19b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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.
Dana’s debt is 2.8 times its EBITDA, and its EBIT cover its interest expense 3.3 times over. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. However, it should be some comfort for shareholders to recall that Dana actually grew its EBIT by a hefty 108%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Dana’s ability to maintain a healthy balance sheet going forward.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So it’s worth checking how much of that EBIT is backed by free cash flow. In the last three years, Dana’s free cash flow amounted to 24% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
Our View
Dana’s level of total liabilities and interest cover definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Dana’s debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. There’s no doubt that we learn most about debt from the balance sheet.