We Think Arad Investment & Industrial Development (TLV:ARAD) Is Taking Some Risk With Its 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.' 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. We note that Arad Investment & Industrial Development Ltd. (TLV:ARAD) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Arad Investment & Industrial Development

What Is Arad Investment & Industrial Development's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2022 Arad Investment & Industrial Development had debt of ₪4.15b, up from ₪3.75b in one year. However, because it has a cash reserve of ₪1.07b, its net debt is less, at about ₪3.08b.

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

The latest balance sheet data shows that Arad Investment & Industrial Development had liabilities of ₪1.45b due within a year, and liabilities of ₪4.42b falling due after that. On the other hand, it had cash of ₪1.07b and ₪920.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₪3.88b.

Given this deficit is actually higher than the company's market capitalization of ₪3.10b, 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 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.

Arad Investment & Industrial Development has a rather high debt to EBITDA ratio of 5.3 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 2.6 times, suggesting it can responsibly service its obligations. More concerning, Arad Investment & Industrial Development saw its EBIT drop by 2.8% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. There's no doubt that we learn most about debt from the balance sheet. But it is Arad Investment & Industrial Development'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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Arad Investment & Industrial Development actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

On the face of it, Arad Investment & Industrial Development's level of total liabilities left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Arad Investment & Industrial Development's debt is making it 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 2 warning signs with Arad Investment & Industrial Development (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.