These 4 Measures Indicate That Shapir Engineering and Industry (TLV:SPEN) Is Using Debt Extensively

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 note that Shapir Engineering and Industry Ltd (TLV:SPEN) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 Net Debt?

The image below, which you can click on for greater detail, shows that at December 2021 Shapir Engineering and Industry had debt of ₪6.19b, up from ₪4.62b in one year. However, because it has a cash reserve of ₪788.8m, its net debt is less, at about ₪5.40b.

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

Zooming in on the latest balance sheet data, we can see that Shapir Engineering and Industry had liabilities of ₪2.38b due within 12 months and liabilities of ₪5.91b due beyond that. Offsetting this, it had ₪788.8m in cash and ₪1.28b in receivables that were due within 12 months. So its liabilities total ₪6.22b more than the combination of its cash and short-term receivables.

Shapir Engineering and Industry has a market capitalization of ₪11.1b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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.

Shapir Engineering and Industry shareholders face the double whammy of a high net debt to EBITDA ratio (8.4), and fairly weak interest coverage, since EBIT is just 2.2 times the interest expense. This means we'd consider it to have a heavy debt load. Even more troubling is the fact that Shapir Engineering and Industry actually let its EBIT decrease by 4.5% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shapir Engineering and Industry 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.

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. Looking at the most recent three years, Shapir Engineering and Industry recorded free cash flow of 42% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Shapir Engineering and Industry's interest cover and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. But at least its conversion of EBIT to free cash flow is not so bad. Overall, we think it's fair to say that Shapir Engineering and Industry has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. For instance, we've identified 2 warning signs for Shapir Engineering and Industry (1 makes us a bit uncomfortable) 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.