We Think Rekah Pharmaceutical Industry (TLV:REKA) Is Taking Some Risk With Its Debt

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.' 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. Importantly, Rekah Pharmaceutical Industry Ltd. (TLV:REKA) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, 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.

See our latest analysis for Rekah Pharmaceutical Industry

How Much Debt Does Rekah Pharmaceutical Industry Carry?

As you can see below, at the end of December 2020, Rekah Pharmaceutical Industry had ₪117.9m of debt, up from ₪93.5m a year ago. Click the image for more detail. On the flip side, it has ₪36.9m in cash leading to net debt of about ₪81.0m.

How Healthy Is Rekah Pharmaceutical Industry's Balance Sheet?

We can see from the most recent balance sheet that Rekah Pharmaceutical Industry had liabilities of ₪108.3m falling due within a year, and liabilities of ₪145.8m due beyond that. Offsetting this, it had ₪36.9m in cash and ₪89.6m in receivables that were due within 12 months. So it has liabilities totalling ₪127.6m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Rekah Pharmaceutical Industry is worth ₪257.7m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

Rekah Pharmaceutical Industry's net debt is sitting at a very reasonable 2.3 times its EBITDA, while its EBIT covered its interest expense just 3.7 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Importantly, Rekah Pharmaceutical Industry grew its EBIT by 66% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Rekah Pharmaceutical Industry'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 always check how much of that EBIT is translated into free cash flow. Over the last three years, Rekah Pharmaceutical Industry 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

Rekah Pharmaceutical Industry's conversion of EBIT to free cash flow and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. When we consider all the factors discussed, it seems to us that Rekah Pharmaceutical Industry is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Rekah Pharmaceutical Industry you should be aware of, and 1 of them is a bit concerning.

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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