Is Adolfo Domínguez (BME:ADZ) Using Debt In A Risky Way?

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 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. We can see that Adolfo Domínguez, S.A. (BME:ADZ) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Adolfo Domínguez

How Much Debt Does Adolfo Domínguez Carry?

The image below, which you can click on for greater detail, shows that at November 2020 Adolfo Domínguez had debt of €15.8m, up from €1.63m in one year. On the flip side, it has €13.9m in cash leading to net debt of about €1.98m.

How Healthy Is Adolfo Domínguez's Balance Sheet?

The latest balance sheet data shows that Adolfo Domínguez had liabilities of €28.7m due within a year, and liabilities of €39.1m falling due after that. On the other hand, it had cash of €13.9m and €7.46m worth of receivables due within a year. So it has liabilities totalling €46.5m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of €39.5m, 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. 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 Adolfo Domínguez'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.

In the last year Adolfo Domínguez had a loss before interest and tax, and actually shrunk its revenue by 30%, to €79m. To be frank that doesn't bode well.

Caveat Emptor

While Adolfo Domínguez'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 €12m. When we look at that alongside the significant liabilities, we're not particularly confident about the company. We'd want to see some strong near-term improvements before getting too interested in the stock. Not least because it burned through €220k in negative free cash flow over the last year. That means it's on the risky side of things. 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. Be aware that Adolfo Domínguez is showing 2 warning signs in our investment analysis , 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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