Elco (TLV:ELCO) Use Of Debt Could Be Considered Risky

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Elco Ltd. (TLV:ELCO) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Elco

How Much Debt Does Elco Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Elco had ₪9.21b of debt, an increase on ₪8.02b, over one year. However, it does have ₪1.91b in cash offsetting this, leading to net debt of about ₪7.30b.

How Healthy Is Elco's Balance Sheet?

According to the last reported balance sheet, Elco had liabilities of ₪10.5b due within 12 months, and liabilities of ₪10.4b due beyond 12 months. Offsetting these obligations, it had cash of ₪1.91b as well as receivables valued at ₪5.82b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₪13.1b.

The deficiency here weighs heavily on the ₪3.13b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Elco would probably need a major re-capitalization if its creditors were to demand repayment.

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.

Weak interest cover of 1.1 times and a disturbingly high net debt to EBITDA ratio of 8.7 hit our confidence in Elco like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even more troubling is the fact that Elco actually let its EBIT decrease by 9.9% over the last year. 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 you can't view debt in total isolation; since Elco 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Elco saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Elco's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And even its net debt to EBITDA fails to inspire much confidence. Considering all the factors previously mentioned, we think that Elco really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Elco has 2 warning signs we think you should be aware of.

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.