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

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.' 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. Importantly, Afcon Holdings Ltd (TLV:AFHL) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Afcon Holdings

What Is Afcon Holdings's Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Afcon Holdings had debt of ₪656.1m, up from ₪505.2m in one year. However, it also had ₪488.7m in cash, and so its net debt is ₪167.4m.

How Healthy Is Afcon Holdings' Balance Sheet?

According to the last reported balance sheet, Afcon Holdings had liabilities of ₪803.3m due within 12 months, and liabilities of ₪573.6m due beyond 12 months. Offsetting this, it had ₪488.7m in cash and ₪686.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₪201.7m.

Of course, Afcon Holdings has a market capitalization of ₪1.05b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Afcon Holdings has a debt to EBITDA ratio of 4.2, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 1k is very high, suggesting that the interest expense on the debt is currently quite low. We also note that Afcon Holdings improved its EBIT from a last year's loss to a positive ₪25m. There's no doubt that we learn most about debt from the balance sheet. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, Afcon Holdings actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Happily, Afcon Holdings's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its net debt to EBITDA has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Afcon Holdings can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 4 warning signs we've spotted with Afcon Holdings (including 2 which can't be ignored) .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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