David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Digi International Carry?
The image below, which you can click on for greater detail, shows that Digi International had debt of US$151.6m at the end of June 2024, a reduction from US$210.1m over a year. However, it also had US$28.3m in cash, and so its net debt is US$123.3m.
How Healthy Is Digi International's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Digi International had liabilities of US$82.4m due within 12 months and liabilities of US$175.0m due beyond that. On the other hand, it had cash of US$28.3m and US$71.2m worth of receivables due within a year. So it has liabilities totalling US$157.8m more than its cash and near-term receivables, combined.
Since publicly traded Digi International shares are worth a total of US$1.04b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Digi International has a quite reasonable net debt to EBITDA multiple of 1.5, its interest cover seems weak, at 1.6. This does have us wondering if the company pays high interest because it is considered risky. In any case, it's safe to say the company has meaningful debt. Sadly, Digi International's EBIT actually dropped 9.7% 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Digi International 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding 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
When it comes to the balance sheet, the standout positive for Digi International was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. In particular, interest cover gives us cold feet. Considering this range of data points, we think Digi International is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Digi International you should be aware of.
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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an 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 account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
