These 4 Measures Indicate That Elspec Engineering (TLV:ELSPC) Is Using Debt Reasonably Well

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. As with many other companies Elspec Engineering Ltd (TLV:ELSPC) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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 Elspec Engineering

What Is Elspec Engineering's Debt?

You can click the graphic below for the historical numbers, but it shows that Elspec Engineering had ₪7.35m of debt in December 2020, down from ₪11.6m, one year before. However, its balance sheet shows it holds ₪31.7m in cash, so it actually has ₪24.3m net cash.

A Look At Elspec Engineering's Liabilities

According to the last reported balance sheet, Elspec Engineering had liabilities of ₪14.7m due within 12 months, and liabilities of ₪7.38m due beyond 12 months. Offsetting this, it had ₪31.7m in cash and ₪9.71m in receivables that were due within 12 months. So it actually has ₪19.3m more liquid assets than total liabilities.

This excess liquidity suggests that Elspec Engineering is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Elspec Engineering has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Elspec Engineering if management cannot prevent a repeat of the 64% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is Elspec Engineering'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Elspec Engineering may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Elspec Engineering actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

While it is always sensible to investigate a company's debt, in this case Elspec Engineering has ₪24.3m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 109% of that EBIT to free cash flow, bringing in ₪9.6m. So we don't think Elspec Engineering's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 4 warning signs with Elspec Engineering , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

If you’re looking to trade Elspec Engineering, open an account with the lowest-cost* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.