Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. Like many other companies Domino’s Pizza Enterprises Limited (ASX:DMP) uses debt. But should shareholders worry about its use of debt?
What risk does debt carry?
Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. Of course, many companies use debt to finance their growth, without any negative consequences. When we look at debt levels, we first consider cash and debt levels, together.
Check out our latest analysis for Domino’s Pizza Enterprises
How much debt does Domino’s Pizza Enterprises have?
As you can see below, at the end of January 2022, Domino’s Pizza Enterprises had A$594.2 million in debt, up from A$562.2 million a year ago. Click on the image for more details. On the other hand, he has A$107.6 million in cash, resulting in a net debt of around A$486.6 million.
A look at the liabilities of Domino’s Pizza Enterprises
According to the last published balance sheet, Domino’s Pizza Enterprises had liabilities of A$702.6 million due within 12 months and liabilities of A$1.37 billion due beyond 12 months. On the other hand, it had cash of A$107.6 million and A$160.0 million of receivables due within one year. Thus, its liabilities total A$1.80 billion more than the combination of its cash and short-term receivables.
This shortfall is not that bad as Domino’s Pizza Enterprises is worth A$5.89 billion and therefore could probably raise enough capital to shore up its balance sheet, should the need arise. But we definitely want to keep our eyes peeled for indications that its debt is too risky.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
We would say Domino’s Pizza Enterprises’ moderate net debt to EBITDA ratio (1.6) is indicative of leverage caution. And its towering EBIT of 19.6 times its interest expense means that the debt burden is as light as a peacock feather. Fortunately, Domino’s Pizza Enterprises has grown its EBIT by 5.5% over the past year, making this debt even more manageable. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Domino’s Pizza Enterprises can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Domino’s Pizza Enterprises has had free cash flow of 63% of its EBIT, which is about normal given that free cash flow excludes interest and taxes. This cold hard cash allows him to reduce his debt whenever he wants.
Our point of view
The good news is that Domino’s Pizza Enterprises’ demonstrated ability to cover its interest costs with its EBIT delights us like a fluffy puppy does a toddler. And this is only the beginning of good news since its conversion of EBIT into free cash flow is also very pleasing. All told, it looks like Domino’s Pizza Enterprises can comfortably handle its current level of debt. On the plus side, this leverage can increase shareholder returns, but the potential downside is greater risk of loss, so it’s worth keeping an eye on the balance sheet. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist outside of the balance sheet. These risks can be difficult to spot. Every business has them, and we’ve spotted 2 warning signs for Domino’s Pizza Enterprises you should know.
If you are interested in investing in companies that can generate profits without the burden of debt, then check out this free list of growing companies that have net cash on the balance sheet.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.