Is Afcon Holdings (TLV:AFHL) Using Too Much Debt?

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. As with many other companies Afcon Holdings Ltd (TLV:AFHL) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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

How Much Debt Does Afcon Holdings Carry?

As you can see below, at the end of September 2020, Afcon Holdings had ₪633.4m of debt, up from ₪501.1m a year ago. Click the image for more detail. However, it does have ₪373.5m in cash offsetting this, leading to net debt of about ₪259.9m.

A Look At Afcon Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that Afcon Holdings had liabilities of ₪702.4m due within 12 months and liabilities of ₪619.1m due beyond that. Offsetting these obligations, it had cash of ₪373.5m as well as receivables valued at ₪768.7m due within 12 months. So it has liabilities totalling ₪179.3m more than its cash and near-term receivables, combined.

Afcon Holdings has a market capitalization of ₪731.8m, so it could very likely raise cash to ameliorate 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 (8.3), and fairly weak interest coverage, since EBIT is just 1.6 times the interest expense. This means we'd consider it to have a heavy debt load. One redeeming factor for Afcon Holdings is that it turned last year's EBIT loss into a gain of ₪13m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is Afcon Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the most recent year, Afcon Holdings recorded free cash flow worth 51% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

While Afcon Holdings's interest cover makes us cautious about it, its track record of managing its debt, based on its EBITDA, is no better. But its not so bad at converting EBIT to free cash flow. When we consider all the factors discussed, it seems to us that Afcon Holdings is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. 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, and 2 of them are potentially serious.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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. 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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