We Think Elco (TLV:ELCO) Can Stay On Top Of Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We can see that Elco Ltd. (TLV:ELCO) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. 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 Elco had US$950.1m of debt in March 2021, down from US$1.00b, one year before. However, it also had US$365.7m in cash, and so its net debt is US$584.4m.

How Healthy Is Elco's Balance Sheet?

We can see from the most recent balance sheet that Elco had liabilities of US$1.56b falling due within a year, and liabilities of US$1.09b due beyond that. On the other hand, it had cash of US$365.7m and US$1.10b worth of receivables due within a year. So it has liabilities totalling US$1.18b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of US$1.58b, so it does suggest shareholders should keep an eye on Elco's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

We'd say that Elco's moderate net debt to EBITDA ratio ( being 2.1), indicates prudence when it comes to debt. And its commanding EBIT of 14.0 times its interest expense, implies the debt load is as light as a peacock feather. We note that Elco grew its EBIT by 24% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But it is Elco'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Elco's free cash flow amounted to 38% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Both Elco's ability to to cover its interest expense with its EBIT and its EBIT growth rate gave us comfort that it can handle its debt. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the factors mentioned above, we do feel a bit cautious about Elco's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with Elco .

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. 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.
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