Donaco International (ASX:DNA) Has A Somewhat Strained Balance Sheet

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Donaco International Limited (ASX:DNA) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Donaco International

What Is Donaco International's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Donaco International had AU$18.3m of debt, an increase on AU$16.9m, over one year. However, it also had AU$17.0m in cash, and so its net debt is AU$1.38m.

How Healthy Is Donaco International's Balance Sheet?

The latest balance sheet data shows that Donaco International had liabilities of AU$51.9m due within a year, and liabilities of AU$9.16m falling due after that. On the other hand, it had cash of AU$17.0m and AU$133.7k worth of receivables due within a year. So it has liabilities totalling AU$44.0m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of AU$42.0m, we think shareholders really should watch Donaco International's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

Donaco International has a very low debt to EBITDA ratio of 0.16 so it is strange to see weak interest coverage, with last year's EBIT being only 0.96 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. We also note that Donaco International improved its EBIT from a last year's loss to a positive AU$2.3m. When analysing debt levels, the balance sheet is the obvious place to start. But it is Donaco International's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, Donaco International actually produced more free cash flow than EBIT over the last year. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

We feel some trepidation about Donaco International's difficulty interest cover, but we've got positives to focus on, too. For example, its conversion of EBIT to free cash flow and net debt to EBITDA give us some confidence in its ability to manage its debt. Looking at all the angles mentioned above, it does seem to us that Donaco International is a somewhat risky investment as a result of its debt. 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. Be aware that Donaco International is showing 1 warning sign in our investment analysis , you should know about...

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.