Is Domino's Pizza Enterprises (ASX:DMP) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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, Domino's Pizza Enterprises Limited (ASX:DMP) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Domino's Pizza Enterprises

How Much Debt Does Domino's Pizza Enterprises Carry?

As you can see below, Domino's Pizza Enterprises had AU$762.4m of debt at June 2024, down from AU$979.5m a year prior. However, because it has a cash reserve of AU$87.7m, its net debt is less, at about AU$674.7m.

How Healthy Is Domino's Pizza Enterprises' Balance Sheet?

The latest balance sheet data shows that Domino's Pizza Enterprises had liabilities of AU$544.8m due within a year, and liabilities of AU$1.44b falling due after that. On the other hand, it had cash of AU$87.7m and AU$186.7m worth of receivables due within a year. So its liabilities total AU$1.71b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Domino's Pizza Enterprises has a market capitalization of AU$3.02b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Domino's Pizza Enterprises has a debt to EBITDA ratio of 2.7 and its EBIT covered its interest expense 5.4 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Domino's Pizza Enterprises grew its EBIT by 5.7% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. There's no doubt that we learn most about debt from the balance sheet. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Domino's Pizza Enterprises's free cash flow amounted to 41% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

While Domino's Pizza Enterprises's net debt to EBITDA makes us cautious about it, its track record of staying on top of its total liabilities is no better. At least its EBIT growth rate gives us reason to be optimistic. We think that Domino's Pizza Enterprises's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Domino's Pizza Enterprises you should be aware of.

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.