Here's Why Donaco International (ASX:DNA) Can Afford Some Debt

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Donaco International Limited (ASX:DNA) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. 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?

The chart below, which you can click on for greater detail, shows that Donaco International had AU$11.7m in debt in December 2021; about the same as the year before. On the flip side, it has AU$4.38m in cash leading to net debt of about AU$7.35m.

How Strong Is Donaco International's Balance Sheet?

We can see from the most recent balance sheet that Donaco International had liabilities of AU$30.2m falling due within a year, and liabilities of AU$8.05m due beyond that. On the other hand, it had cash of AU$4.38m and AU$158.9k worth of receivables due within a year. So it has liabilities totalling AU$33.8m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of AU$53.1m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Donaco International will need earnings to service that debt. 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.

Over 12 months, Donaco International made a loss at the EBIT level, and saw its revenue drop to AU$5.1m, which is a fall of 73%. That makes us nervous, to say the least.

Caveat Emptor

While Donaco International's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Its EBIT loss was a whopping AU$12m. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Another cause for caution is that is bled AU$8.6m in negative free cash flow over the last twelve months. So in short it's a really risky stock. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Donaco International (of which 2 make us uncomfortable!) you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.