Here's Why Domino's Pizza Enterprises (ASX:DMP) Can Manage Its Debt Responsibly

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Domino's Pizza Enterprises Limited (ASX:DMP) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Domino's Pizza Enterprises

What Is Domino's Pizza Enterprises's Debt?

The image below, which you can click on for greater detail, shows that at January 2022 Domino's Pizza Enterprises had debt of AU$594.2m, up from AU$562.2m in one year. However, it does have AU$107.6m in cash offsetting this, leading to net debt of about AU$486.6m.

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$702.6m falling due within a year, and liabilities of AU$1.37b due beyond that. Offsetting this, it had AU$107.6m in cash and AU$160.0m in receivables that were due within 12 months. So it has liabilities totalling AU$1.80b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Domino's Pizza Enterprises has a market capitalization of AU$6.97b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Domino's Pizza Enterprises's net debt to EBITDA ratio of about 1.6 suggests only moderate use of debt. And its commanding EBIT of 19.6 times its interest expense, implies the debt load is as light as a peacock feather. The good news is that Domino's Pizza Enterprises has increased its EBIT by 5.5% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Domino's Pizza Enterprises 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Domino's Pizza Enterprises produced sturdy free cash flow equating to 63% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Domino's Pizza Enterprises's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Looking at all the aforementioned factors together, it strikes us that Domino's Pizza Enterprises can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with Domino's Pizza Enterprises .

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.