Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Equital Ltd. (TLV:EQTL) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
What Is Equital's Debt?
The chart below, which you can click on for greater detail, shows that Equital had ₪8.13b in debt in June 2021; about the same as the year before. However, because it has a cash reserve of ₪1.85b, its net debt is less, at about ₪6.28b.
How Strong Is Equital's Balance Sheet?
We can see from the most recent balance sheet that Equital had liabilities of ₪2.23b falling due within a year, and liabilities of ₪8.44b due beyond that. Offsetting this, it had ₪1.85b in cash and ₪448.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₪8.38b.
This deficit casts a shadow over the ₪3.48b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Equital would likely require a major re-capitalisation if it had to pay its creditors today.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Equital's net debt is 3.8 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 14.8 is very high, suggesting that the interest expense on the debt is currently quite low. Importantly, Equital's EBIT fell a jaw-dropping 21% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Equital 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Equital recorded free cash flow worth a fulsome 97% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
On the face of it, Equital's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. 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. There's no doubt that we learn most about debt from the balance sheet. 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 2 warning signs for Equital (of which 1 is significant!) 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.
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.
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