Israel (TLV:ILCO) Has A Pretty Healthy Balance Sheet

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Israel Corporation Ltd (TLV:ILCO) 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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Israel

What Is Israel's Debt?

You can click the graphic below for the historical numbers, but it shows that Israel had US$4.00b of debt in June 2022, down from US$4.58b, one year before. However, it also had US$1.16b in cash, and so its net debt is US$2.84b.

How Healthy Is Israel's Balance Sheet?

We can see from the most recent balance sheet that Israel had liabilities of US$3.16b falling due within a year, and liabilities of US$4.46b due beyond that. On the other hand, it had cash of US$1.16b and US$2.39b worth of receivables due within a year. So its liabilities total US$4.06b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of US$3.08b, we think shareholders really should watch Israel's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). 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).

Israel has a low net debt to EBITDA ratio of only 0.89. And its EBIT easily covers its interest expense, being 17.5 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that Israel grew its EBIT by 255% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Israel will need earnings to service that debt. 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 always check how much of that EBIT is translated into free cash flow. In the last three years, Israel's free cash flow amounted to 49% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Israel's interest cover was a real positive on this analysis, as was its EBIT growth rate. In contrast, our confidence was undermined by its apparent struggle to handle its total liabilities. When we consider all the factors mentioned above, we do feel a bit cautious about Israel's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Israel , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.