Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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, Domino's Pizza Enterprises Limited (ASX:DMP) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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.
What Is Domino's Pizza Enterprises's Debt?
As you can see below, Domino's Pizza Enterprises had AU$508.3m of debt at June 2021, down from AU$708.7m a year prior. However, it does have AU$174.7m in cash offsetting this, leading to net debt of about AU$333.6m.
A Look At Domino's Pizza Enterprises' Liabilities
We can see from the most recent balance sheet that Domino's Pizza Enterprises had liabilities of AU$538.8m falling due within a year, and liabilities of AU$1.42b due beyond that. Offsetting these obligations, it had cash of AU$174.7m as well as receivables valued at AU$216.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$1.57b.
Given Domino's Pizza Enterprises has a market capitalization of AU$13.4b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Domino's Pizza Enterprises's net debt is only 1.0 times its EBITDA. And its EBIT covers its interest expense a whopping 19.6 times over. So we're pretty relaxed about its super-conservative use of debt. Another good sign is that Domino's Pizza Enterprises has been able to increase its EBIT by 29% in twelve months, making it easier to pay down debt. 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 Domino's Pizza Enterprises's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
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. During the last three years, Domino's Pizza Enterprises produced sturdy free cash flow equating to 69% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
The good news is that Domino's Pizza Enterprises's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Considering this range of factors, it seems to us that Domino's Pizza Enterprises is quite prudent with its debt, and the risks seem well managed. So we're not worried about the use of a little leverage on the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Domino's Pizza Enterprises , and understanding them should be part of your investment process.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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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.
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