Is Domain Holdings Australia (ASX:DHG) 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.' 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, Domain Holdings Australia Limited (ASX:DHG) does carry debt. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Domain Holdings Australia

How Much Debt Does Domain Holdings Australia Carry?

The image below, which you can click on for greater detail, shows that at December 2020 Domain Holdings Australia had debt of AU$172.1m, up from AU$162.1m in one year. However, it also had AU$60.5m in cash, and so its net debt is AU$111.5m.

A Look At Domain Holdings Australia's Liabilities

The latest balance sheet data shows that Domain Holdings Australia had liabilities of AU$55.4m due within a year, and liabilities of AU$286.5m falling due after that. Offsetting this, it had AU$60.5m in cash and AU$51.2m in receivables that were due within 12 months. So it has liabilities totalling AU$230.1m more than its cash and near-term receivables, combined.

Of course, Domain Holdings Australia has a market capitalization of AU$2.79b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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).

Domain Holdings Australia's net debt of 1.7 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 8.3 times interest expense) certainly does not do anything to dispel this impression. Domain Holdings Australia grew its EBIT by 3.8% 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 Domain Holdings Australia's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Domain Holdings Australia generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

The good news is that Domain Holdings Australia's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And we also thought its interest cover was a positive. When we consider the range of factors above, it looks like Domain Holdings Australia is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Even though Domain Holdings Australia lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.

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. 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.
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