While modern Linux distributions use partition schemes and filesystems that are compatible with both USB drives and optical media at the same time, Windows ISOs only work on DVDs.
This is because they use the UDF filesystem, which most BIOSes don’t support on USB drives.
In order to make Windows ISOs work with EtchDroid they must first be converted to a different filesystem.
Writing DMG images is a very uncommon use case and maintaining support for them is a lot of work. I’ve decided to remove support for them in order to focus on stability and performance.
The short answer is that Android doesn’t support the filesystem types used by most operating system ISOs. You can safely ignore the warning and keep going.
There’s a separate page with further explanations and instructions on how to format the USB drive once you’re done using it.
Unfortunately, Android does not allow apps to write to the internal SD card slot in the way that is required in order to write disk images.
Only USB devices can ever be supported.
Other apps might be able to get around this limitation by using root access; EtchDroid does not require root and will never do so.
You can ask the community on GitHub.