Afcon Holdings (TLV:AFHL) Use Of Debt Could Be Considered Risky

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 Afcon Holdings Ltd (TLV:AFHL) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

See our latest analysis for Afcon Holdings

What Is Afcon Holdings's Net Debt?

As you can see below, Afcon Holdings had ₪612.6m of debt, at September 2022, which is about the same as the year before. You can click the chart for greater detail. However, it does have ₪174.9m in cash offsetting this, leading to net debt of about ₪437.7m.

How Strong Is Afcon Holdings' Balance Sheet?

According to the last reported balance sheet, Afcon Holdings had liabilities of ₪853.7m due within 12 months, and liabilities of ₪464.8m due beyond 12 months. Offsetting this, it had ₪174.9m in cash and ₪799.7m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₪343.9m.

This deficit isn't so bad because Afcon Holdings is worth ₪574.9m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Afcon Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (29.1), and fairly weak interest coverage, since EBIT is just 0.30 times the interest expense. The debt burden here is substantial. Even worse, Afcon Holdings saw its EBIT tank 95% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Afcon Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. In the last three years, Afcon Holdings created free cash flow amounting to 4.5% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On the face of it, Afcon Holdings's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And even its conversion of EBIT to free cash flow fails to inspire much confidence. Taking into account all the aforementioned factors, it looks like Afcon Holdings has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Afcon Holdings 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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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.