These 4 Measures Indicate That Naphtha Israel Petroleum (TLV:NFTA) 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.' 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. We note that Naphtha Israel Petroleum Corp. Ltd. (TLV:NFTA) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Naphtha Israel Petroleum

What Is Naphtha Israel Petroleum's Net Debt?

The image below, which you can click on for greater detail, shows that Naphtha Israel Petroleum had debt of ₪2.31b at the end of March 2021, a reduction from ₪2.47b over a year. On the flip side, it has ₪690.4m in cash leading to net debt of about ₪1.62b.

How Strong Is Naphtha Israel Petroleum's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Naphtha Israel Petroleum had liabilities of ₪580.8m due within 12 months and liabilities of ₪2.30b due beyond that. Offsetting these obligations, it had cash of ₪690.4m as well as receivables valued at ₪184.8m due within 12 months. So its liabilities total ₪2.00b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's ₪1.48b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

We'd say that Naphtha Israel Petroleum's moderate net debt to EBITDA ratio ( being 1.6), indicates prudence when it comes to debt. And its strong interest cover of 11.3 times, makes us even more comfortable. It is just as well that Naphtha Israel Petroleum's load is not too heavy, because its EBIT was down 43% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Naphtha Israel Petroleum'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 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. Over the last three years, Naphtha Israel Petroleum actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

On the face of it, Naphtha Israel Petroleum's level of total liabilities left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Naphtha Israel Petroleum's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. We've identified 1 warning sign with Naphtha Israel Petroleum , and understanding them should be part of your investment process.

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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