Is Domino's Pizza Enterprises (ASX:DMP) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, Domino's Pizza Enterprises Limited (ASX:DMP) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Domino's Pizza Enterprises

How Much Debt Does Domino's Pizza Enterprises Carry?

The image below, which you can click on for greater detail, shows that at December 2023 Domino's Pizza Enterprises had debt of AU$868.9m, up from AU$807.2m in one year. However, it does have AU$117.4m in cash offsetting this, leading to net debt of about AU$751.5m.

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$604.5m falling due within a year, and liabilities of AU$1.62b due beyond that. Offsetting this, it had AU$117.4m in cash and AU$197.5m in receivables that were due within 12 months. So it has liabilities totalling AU$1.91b 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$3.39b, 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.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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 has a debt to EBITDA ratio of 2.8 and its EBIT covered its interest expense 5.6 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Unfortunately, Domino's Pizza Enterprises's EBIT flopped 20% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. 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 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. In the last three years, Domino's Pizza Enterprises's free cash flow amounted to 48% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over Domino's Pizza Enterprises's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But at least its conversion of EBIT to free cash flow is not so bad. Once we consider all the factors above, together, it seems to us that Domino's Pizza Enterprises's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Case in point: We've spotted 4 warning signs for Domino's Pizza Enterprises you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.