Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. Importantly, Ducommun Incorporated (NYSE:DCO) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Ducommun’s Debt?
You can click the graphic below for the historical numbers, but it shows that Ducommun had US$298.0m of debt in October 2021, down from US$347.3m, one year before. However, because it has a cash reserve of US$8.97m, its net debt is less, at about US$289.1m.
How Healthy Is Ducommun’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Ducommun had liabilities of US$134.2m due within 12 months and liabilities of US$344.6m due beyond that. Offsetting these obligations, it had cash of US$8.97m as well as receivables valued at US$252.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$217.3m.
Ducommun has a market capitalization of US$527.8m, so it could very likely raise cash to ameliorate 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.
Ducommun’s debt is 3.7 times its EBITDA, and its EBIT cover its interest expense 4.5 times over. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Sadly, Ducommun’s EBIT actually dropped 4.1% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Ducommun can strengthen its balance sheet over time.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Ducommun reported free cash flow worth 11% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
On the face of it, Ducommun’s net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to handle its total liabilities isn’t such a worry. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Ducommun stock a bit risky.