We Think Hod Assaf Industries (TLV:HOD) Is Taking Some Risk With Its Debt

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 can see that Hod Assaf Industries Ltd. (TLV:HOD) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Hod Assaf Industries

What Is Hod Assaf Industries's Debt?

The image below, which you can click on for greater detail, shows that at December 2022 Hod Assaf Industries had debt of ₪307.2m, up from ₪174.0m in one year. However, it does have ₪12.7m in cash offsetting this, leading to net debt of about ₪294.5m.

How Healthy Is Hod Assaf Industries' Balance Sheet?

We can see from the most recent balance sheet that Hod Assaf Industries had liabilities of ₪561.5m falling due within a year, and liabilities of ₪28.7m due beyond that. Offsetting this, it had ₪12.7m in cash and ₪460.2m in receivables that were due within 12 months. So its liabilities total ₪117.3m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Hod Assaf Industries is worth ₪472.2m, 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.

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).

Hod Assaf Industries's debt is 3.0 times its EBITDA, and its EBIT cover its interest expense 5.3 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Importantly, Hod Assaf Industries's EBIT fell a jaw-dropping 54% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But it is Hod Assaf Industries'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Hod Assaf Industries recorded free cash flow of 43% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

We'd go so far as to say Hod Assaf Industries's EBIT growth rate was disappointing. Having said that, its ability to handle its total liabilities isn't such a worry. Once we consider all the factors above, together, it seems to us that Hod Assaf Industries'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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Hod Assaf Industries (of which 1 is concerning!) 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.