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.' 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. We can see that Domiki Kritis S.A. (ATH:DOMIK) 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 assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Domiki Kritis's Net Debt?
As you can see below, Domiki Kritis had €6.39m of debt at December 2020, down from €6.76m a year prior. However, it also had €1.91m in cash, and so its net debt is €4.49m.
How Healthy Is Domiki Kritis' Balance Sheet?
We can see from the most recent balance sheet that Domiki Kritis had liabilities of €9.25m falling due within a year, and liabilities of €4.13m due beyond that. Offsetting this, it had €1.91m in cash and €5.23m in receivables that were due within 12 months. So it has liabilities totalling €6.24m more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of €8.23m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Domiki Kritis's net debt is sitting at a very reasonable 2.2 times its EBITDA, while its EBIT covered its interest expense just 3.4 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Pleasingly, Domiki Kritis is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 127% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is Domiki Kritis's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Domiki Kritis actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Domiki Kritis's conversion of EBIT to free cash flow and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. When we consider all the factors discussed, it seems to us that Domiki Kritis is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Domiki Kritis you should be aware of.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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