Elco (TLV:ELCO) Seems To Be Using A Lot Of 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. As with many other companies Elco Ltd. (TLV:ELCO) makes use of debt. But the more important question is: how much risk is that debt creating?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Elco

What Is Elco's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Elco had ₪8.71b of debt, an increase on ₪7.82b, over one year. However, because it has a cash reserve of ₪1.44b, its net debt is less, at about ₪7.27b.

A Look At Elco's Liabilities

The latest balance sheet data shows that Elco had liabilities of ₪10.7b due within a year, and liabilities of ₪9.57b falling due after that. On the other hand, it had cash of ₪1.44b and ₪5.70b worth of receivables due within a year. So it has liabilities totalling ₪13.2b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the ₪2.25b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Elco would likely require a major re-capitalisation if it had to pay its creditors today.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Elco shareholders face the double whammy of a high net debt to EBITDA ratio (9.6), and fairly weak interest coverage, since EBIT is just 1.00 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Elco's EBIT was down 58% over the last year. 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 Elco will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Elco saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Elco's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. It looks to us like Elco carries a significant balance sheet burden. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. 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. Be aware that Elco is showing 2 warning signs in our investment analysis , you should know about...

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.