Here's Why Elco (TLV:ELCO) Has A Meaningful Debt Burden

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 can see that Elco Ltd. (TLV:ELCO) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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.

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What Is Elco's Debt?

The image below, which you can click on for greater detail, shows that at June 2022 Elco had debt of ₪6.60b, up from ₪4.60b in one year. However, it does have ₪1.90b in cash offsetting this, leading to net debt of about ₪4.70b.

A Look At Elco's Liabilities

Zooming in on the latest balance sheet data, we can see that Elco had liabilities of ₪8.74b due within 12 months and liabilities of ₪7.85b due beyond that. Offsetting this, it had ₪1.90b in cash and ₪4.33b in receivables that were due within 12 months. So its liabilities total ₪10.4b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the ₪5.33b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. 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). 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's net debt of 1.9 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 9.5 times interest expense) certainly does not do anything to dispel this impression. Notably, Elco's EBIT launched higher than Elon Musk, gaining a whopping 135% on last year. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Elco's earnings that will influence how the balance sheet holds up in the future. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Elco reported free cash flow worth 8.1% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Mulling over Elco's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But on the bright side, its EBIT growth rate 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 Elco stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. Case in point: We've spotted 1 warning sign for Elco you should be aware of.

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.

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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.