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.’ 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. As with many other companies Equital Ltd. (TLV:EQTL) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Equital Carry?
The chart below, which you can click on for greater detail, shows that Equital had ₪8.10b in debt in September 2022; about the same as the year before. However, it does have ₪1.89b in cash offsetting this, leading to net debt of about ₪6.20b.
How Healthy Is Equital’s Balance Sheet?
We can see from the most recent balance sheet that Equital had liabilities of ₪2.60b falling due within a year, and liabilities of ₪9.08b due beyond that. Offsetting these obligations, it had cash of ₪1.89b as well as receivables valued at ₪574.7m due within 12 months. So its liabilities total ₪9.21b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the ₪3.43b 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, Equital would probably need a major re-capitalization if its creditors were to demand repayment.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Equital’s debt is 3.5 times its EBITDA, and its EBIT cover its interest expense 5.3 times over. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. We note that Equital grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since Equital 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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Equital recorded free cash flow worth a fulsome 89% of its EBIT, which is stronger than we’d usually expect. That positions it well to pay down debt if desirable to do so.
Neither Equital’s ability to handle its total liabilities nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Equital is a somewhat risky investment as a result of its debt. That’s not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. These risks can be hard to spot. Every company has them, and we’ve spotted 2 warning signs for Equital (of which 1 doesn’t sit too well with us!) you should know about.
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.
Valuation is complex, but we’re helping make it simple.
Find out whether Equital is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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