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, Dayforce Inc. (NYSE:DAY) does carry debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Dayforce's Net Debt?

As you can see below, Dayforce had US$1.21b of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$465.4m in cash leading to net debt of about US$745.7m.

How Strong Is Dayforce's Balance Sheet?

We can see from the most recent balance sheet that Dayforce had liabilities of US$5.28b falling due within a year, and liabilities of US$1.29b due beyond that. Offsetting these obligations, it had cash of US$465.4m as well as receivables valued at US$260.7m due within 12 months. So its liabilities total US$5.84b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Dayforce is worth a massive US$10.3b, 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.

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.

Dayforce has a debt to EBITDA ratio of 3.1 and its EBIT covered its interest expense 2.6 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. On a slightly more positive note, Dayforce grew its EBIT at 19% over the last year, further increasing its ability to manage 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 Dayforce's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last two years, Dayforce recorded free cash flow worth a fulsome 99% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

On our analysis Dayforce's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. In particular, interest cover gives us cold feet. Considering this range of data points, we think Dayforce is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Dayforce , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.