Is DOF (OB:DOF) A Risky Investment?

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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 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. As with many other companies. DOF ASA (OB:DOF) makes use of debt. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for DOF

What Is DOF’s Net Debt?

The image below, which you can click on for greater detail, shows that at March 2019 DOF had debt of øre18.8b, up from øre18.0b in one year. However, because it has a cash reserve of øre1.28b, its net debt is less, at about øre17.6b.

OB:DOF Historical Debt, July 17th 2019
OB:DOF Historical Debt, July 17th 2019

How Strong Is DOF’s Balance Sheet?

The latest balance sheet data shows that DOF had liabilities of øre5.19b due within a year, and liabilities of øre15.5b falling due after that. On the other hand, it had cash of øre1.28b and øre1.71b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by øre17.7b.

This deficit casts a shadow over the øre1.03b company, like a colossus towering over mere mortals. So we’d watch its balance sheet closely, without a doubt At the end of the day, DOF would probably need a major re-capitalization if its creditors were to demand repayment. Because it carries more debt than cash, we think it’s worth watching DOF’s balance sheet over time.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Weak interest cover of 0.37 times and a disturbingly high net debt to EBITDA ratio of 13.2 hit our confidence in DOF like a one-two punch to the gut. The debt burden here is substantial. Worse, DOF’s EBIT was down 55% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 DOF’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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, DOF recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.

Our View

On the face of it, DOF’s EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its net debt to EBITDA also fails to instill confidence. It looks to us like DOF carries a significant balance sheet burden. If you harvest honey without a bee suit, you risk getting stung, so we’d probably stay away from this particular stock. Even though DOF lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check outhow earnings have been trending over the last few years.

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.