Here's Why Arad Investment & Industrial Development (TLV:ARAD) Has A Meaningful Debt Burden

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. We note that Arad Investment & Industrial Development Ltd. (TLV:ARAD) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Arad Investment & Industrial Development

What Is Arad Investment & Industrial Development's Debt?

As you can see below, Arad Investment & Industrial Development had ₪4.13b of debt, at June 2023, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has ₪664.9m in cash leading to net debt of about ₪3.47b.

How Strong Is Arad Investment & Industrial Development's Balance Sheet?

We can see from the most recent balance sheet that Arad Investment & Industrial Development had liabilities of ₪1.50b falling due within a year, and liabilities of ₪4.43b due beyond that. Offsetting these obligations, it had cash of ₪664.9m as well as receivables valued at ₪1.05b due within 12 months. So it has liabilities totalling ₪4.22b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of ₪2.98b, we think shareholders really should watch Arad Investment & Industrial Development's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.

Arad Investment & Industrial Development has a rather high debt to EBITDA ratio of 5.5 which suggests a meaningful debt load. However, its interest coverage of 2.6 is reasonably strong, which is a good sign. Fortunately, Arad Investment & Industrial Development grew its EBIT by 3.4% in the last year, slowly shrinking its debt relative to earnings. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Arad Investment & Industrial Development 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Arad Investment & Industrial Development recorded free cash flow worth a fulsome 91% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

To be frank both Arad Investment & Industrial Development's level of total liabilities and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Arad Investment & Industrial Development stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. We've identified 3 warning signs with Arad Investment & Industrial Development (at least 1 which is a bit unpleasant) , and understanding them should be part of your investment process.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.