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.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Digi International Inc. (NASDAQ:DGII) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Digi International Carry?
The image below, which you can click on for greater detail, shows that at December 2021 Digi International had debt of US$324.0m, up from US$45.5m in one year. However, it does have US$47.2m in cash offsetting this, leading to net debt of about US$276.8m.
A Look At Digi International’s Liabilities
The latest balance sheet data shows that Digi International had liabilities of US$79.3m due within a year, and liabilities of US$312.9m falling due after that. On the other hand, it had cash of US$47.2m and US$49.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$295.7m.
This deficit isn’t so bad because Digi International is worth US$704.8m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Digi International has a rather high debt to EBITDA ratio of 6.1 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 3.7 times, suggesting it can responsibly service its obligations. The good news is that Digi International grew its EBIT a smooth 42% over the last twelve months. Like a mother’s loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Digi International’s ability to maintain a healthy balance sheet going forward.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Digi International actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Our View
Happily, Digi International’s impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But we must concede we find its net debt to EBITDA has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Digi International can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet.