Gaon Group (TLV:GAGR) Has A Somewhat Strained Balance Sheet

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Gaon Group Ltd. (TLV:GAGR) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Our analysis indicates that GAGR is potentially undervalued!

How Much Debt Does Gaon Group Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Gaon Group had ₪306.7m of debt, an increase on ₪227.5m, over one year. However, it also had ₪40.8m in cash, and so its net debt is ₪265.9m.

A Look At Gaon Group's Liabilities

The latest balance sheet data shows that Gaon Group had liabilities of ₪480.5m due within a year, and liabilities of ₪93.5m falling due after that. On the other hand, it had cash of ₪40.8m and ₪221.9m worth of receivables due within a year. So it has liabilities totalling ₪311.2m more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's ₪254.5m 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.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Gaon Group's debt is 4.4 times its EBITDA, and its EBIT cover its interest expense 3.6 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. However, it should be some comfort for shareholders to recall that Gaon Group actually grew its EBIT by a hefty 145%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Gaon Group'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Gaon Group saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

We'd go so far as to say Gaon Group's conversion of EBIT to free cash flow was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, we think it's fair to say that Gaon Group has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. For example Gaon Group has 5 warning signs (and 2 which don't sit too well with us) we think 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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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.