Shapir Engineering and Industry (TLV:SPEN) Use Of Debt Could Be Considered Risky

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Shapir Engineering and Industry Ltd (TLV:SPEN) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Shapir Engineering and Industry

What Is Shapir Engineering and Industry's Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Shapir Engineering and Industry had debt of ₪8.75b, up from ₪7.86b in one year. However, because it has a cash reserve of ₪1.33b, its net debt is less, at about ₪7.42b.

How Strong Is Shapir Engineering and Industry's Balance Sheet?

According to the last reported balance sheet, Shapir Engineering and Industry had liabilities of ₪4.49b due within 12 months, and liabilities of ₪7.05b due beyond 12 months. On the other hand, it had cash of ₪1.33b and ₪1.94b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₪8.26b.

This is a mountain of leverage relative to its market capitalization of ₪9.14b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

Weak interest cover of 0.50 times and a disturbingly high net debt to EBITDA ratio of 15.2 hit our confidence in Shapir Engineering and Industry like a one-two punch to the gut. The debt burden here is substantial. Even worse, Shapir Engineering and Industry saw its EBIT tank 46% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Shapir Engineering and Industry'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Shapir Engineering and Industry burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Shapir Engineering and Industry's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And even its net debt to EBITDA fails to inspire much confidence. Taking into account all the aforementioned factors, it looks like Shapir Engineering and Industry has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Shapir Engineering and Industry (of which 2 are a bit concerning!) you should know about.

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.