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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Lapidoth Capital Ltd (TLV:LAPD) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
See our latest analysis for Lapidoth Capital
How Much Debt Does Lapidoth Capital Carry?
The image below, which you can click on for greater detail, shows that at September 2020 Lapidoth Capital had debt of ₪2.93b, up from ₪239.1m in one year. On the flip side, it has ₪913.7m in cash leading to net debt of about ₪2.02b.
How Strong Is Lapidoth Capital's Balance Sheet?
The latest balance sheet data shows that Lapidoth Capital had liabilities of ₪3.73b due within a year, and liabilities of ₪1.96b falling due after that. On the other hand, it had cash of ₪913.7m and ₪1.59b worth of receivables due within a year. So it has liabilities totalling ₪3.18b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the ₪1.96b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Lapidoth Capital 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). 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 2.3 times and a disturbingly high net debt to EBITDA ratio of 7.2 hit our confidence in Lapidoth Capital like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. The silver lining is that Lapidoth Capital grew its EBIT by 112% last year, which nourishing like the idealism of youth. If it can keep walking that path it will be in a position to shed its debt with relative ease. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Lapidoth Capital'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 it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Lapidoth Capital's free cash flow amounted to 48% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Our View
On the face of it, Lapidoth Capital's net debt to EBITDA 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 at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Lapidoth Capital's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Lapidoth Capital (of which 1 is significant!) you should know about.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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About TASE:LAPD
Adequate balance sheet with poor track record.