Adolfo Domínguez (BME:ADZ) Has A Somewhat Strained Balance Sheet

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Adolfo Domínguez, S.A. (BME:ADZ) makes use of debt. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. 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, 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 Adolfo Domínguez

What Is Adolfo Domínguez's Debt?

You can click the graphic below for the historical numbers, but it shows that as of February 2023 Adolfo Domínguez had €18.1m of debt, an increase on €16.8m, over one year. However, because it has a cash reserve of €9.28m, its net debt is less, at about €8.79m.

How Strong Is Adolfo Domínguez's Balance Sheet?

We can see from the most recent balance sheet that Adolfo Domínguez had liabilities of €46.7m falling due within a year, and liabilities of €32.9m due beyond that. Offsetting these obligations, it had cash of €9.28m as well as receivables valued at €8.30m due within 12 months. So it has liabilities totalling €62.0m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of €58.1m, we think shareholders really should watch Adolfo Domínguez'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).

While Adolfo Domínguez has a quite reasonable net debt to EBITDA multiple of 2.4, its interest cover seems weak, at 2.0. This does suggest the company is paying fairly high interest rates. In any case, it's safe to say the company has meaningful debt. However, the silver lining was that Adolfo Domínguez achieved a positive EBIT of €2.5m in the last twelve months, an improvement on the prior year's loss. 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 Adolfo Domínguez'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Adolfo Domínguez produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Both Adolfo Domínguez's interest cover and its level of total liabilities were discouraging. But at least its conversion of EBIT to free cash flow is a gleaming silver lining to those clouds. Taking the abovementioned factors together we do think Adolfo Domínguez's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start. 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 Adolfo Domínguez (of which 2 are concerning!) you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.