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. As with many other companies DFI Retail Group Holdings Limited (SGX:D01) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

What Is DFI Retail Group Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that DFI Retail Group Holdings had US$862.2m of debt in June 2024, down from US$1.10b, one year before. However, because it has a cash reserve of US$313.5m, its net debt is less, at about US$548.7m.

How Strong Is DFI Retail Group Holdings' Balance Sheet?

The latest balance sheet data shows that DFI Retail Group Holdings had liabilities of US$3.14b due within a year, and liabilities of US$2.58b falling due after that. Offsetting this, it had US$313.5m in cash and US$234.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$5.17b.

This deficit casts a shadow over the US$3.22b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, DFI Retail Group Holdings would probably need a major re-capitalization if its creditors were to demand repayment.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Given net debt is only 1.4 times EBITDA, it is initially surprising to see that DFI Retail Group Holdings's EBIT has low interest coverage of 1.7 times. So one way or the other, it's clear the debt levels are not trivial. Unfortunately, DFI Retail Group Holdings saw its EBIT slide 5.3% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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 DFI Retail Group Holdings'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, DFI Retail Group Holdings actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

To be frank both DFI Retail Group Holdings's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, we think it's fair to say that DFI Retail Group Holdings has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it.