Here's Why Isramco Negev 2 Limited Partnership (TLV:ISRA.L) Can Manage Its Debt Responsibly

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.' 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 Isramco Negev 2 Limited Partnership (TLV:ISRA.L) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Isramco Negev 2 Limited Partnership

What Is Isramco Negev 2 Limited Partnership's Debt?

As you can see below, Isramco Negev 2 Limited Partnership had US$504.3m of debt at September 2020, down from US$724.7m a year prior. However, because it has a cash reserve of US$70.4m, its net debt is less, at about US$434.0m.

How Healthy Is Isramco Negev 2 Limited Partnership's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Isramco Negev 2 Limited Partnership had liabilities of US$161.6m due within 12 months and liabilities of US$469.5m due beyond that. Offsetting these obligations, it had cash of US$70.4m as well as receivables valued at US$104.0m due within 12 months. So it has liabilities totalling US$456.8m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of US$517.7m, so it does suggest shareholders should keep an eye on Isramco Negev 2 Limited Partnership's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Isramco Negev 2 Limited Partnership has a low net debt to EBITDA ratio of only 1.3. And its EBIT covers its interest expense a whopping 32.6 times over. So we're pretty relaxed about its super-conservative use of debt. On the other hand, Isramco Negev 2 Limited Partnership's EBIT dived 13%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Isramco Negev 2 Limited Partnership 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Isramco Negev 2 Limited Partnership actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Both Isramco Negev 2 Limited Partnership's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to grow its EBIT. Looking at all this data makes us feel a little cautious about Isramco Negev 2 Limited Partnership's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Isramco Negev 2 Limited Partnership is showing 1 warning sign in our investment analysis , 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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