Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Dromeas SA (ATH:DROME) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
See our latest analysis for Dromeas
What Is Dromeas's Net Debt?
As you can see below, Dromeas had €25.1m of debt at December 2018, down from €27.3m a year prior. On the flip side, it has €1.73m in cash leading to net debt of about €23.4m.
How Healthy Is Dromeas's Balance Sheet?
According to the last reported balance sheet, Dromeas had liabilities of €8.91m due within 12 months, and liabilities of €25.2m due beyond 12 months. Offsetting these obligations, it had cash of €1.73m as well as receivables valued at €6.54m due within 12 months. So it has liabilities totalling €25.8m more than its cash and near-term receivables, combined.
This deficit casts a shadow over the €13.4m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Dromeas would likely require a major re-capitalisation if it had to pay its creditors today.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 7.8 hit our confidence in Dromeas like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. The silver lining is that Dromeas grew its EBIT by 459% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Dromeas will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.