Is Gaon Group (TLV:GAGR) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Gaon Group Ltd. (TLV:GAGR) makes use of 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Gaon Group

What Is Gaon Group's Net Debt?

As you can see below, at the end of September 2020, Gaon Group had ₪199.7m of debt, up from ₪132.8m a year ago. Click the image for more detail. However, it also had ₪88.8m in cash, and so its net debt is ₪110.8m.

A Look At Gaon Group's Liabilities

We can see from the most recent balance sheet that Gaon Group had liabilities of ₪347.0m falling due within a year, and liabilities of ₪74.4m due beyond that. On the other hand, it had cash of ₪88.8m and ₪181.2m worth of receivables due within a year. So it has liabilities totalling ₪151.4m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Gaon Group is worth ₪274.2m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Gaon Group has a debt to EBITDA ratio of 3.2 and its EBIT covered its interest expense 4.1 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. More concerning, Gaon Group saw its EBIT drop by 4.0% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. When analysing debt levels, the balance sheet is the obvious place to start. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding 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

Mulling over Gaon Group's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. Having said that, its ability to handle its total liabilities isn't such a worry. Looking at the bigger picture, it seems clear to us that Gaon Group'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. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 6 warning signs for Gaon Group (1 shouldn't be ignored!) that you should be aware of before investing here.

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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