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 Equital Ltd. (TLV:EQTL) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.
How Much Debt Does Equital Carry?
The chart below, which you can click on for greater detail, shows that Equital had ₪8.24b in debt in March 2021; about the same as the year before. On the flip side, it has ₪1.88b in cash leading to net debt of about ₪6.36b.
How Healthy Is Equital's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Equital had liabilities of ₪2.34b due within 12 months and liabilities of ₪8.35b due beyond that. On the other hand, it had cash of ₪1.88b and ₪449.3m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₪8.37b.
The deficiency here weighs heavily on the ₪3.31b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Equital would probably need a major re-capitalization if its creditors were to demand repayment.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Equital has net debt to EBITDA of 3.9 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 9.7 suggests it can easily service that debt. Shareholders should be aware that Equital's EBIT was down 29% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Equital'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Equital generated free cash flow amounting to a very robust 97% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
To be frank both Equital's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the bigger picture, it seems clear to us that Equital's use of debt is creating risks for the company. 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 example Equital has 2 warning signs (and 1 which is concerning) we think you should know about.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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