Africa Israel Residences (TLV:AFRE) Has A Somewhat Strained Balance Sheet

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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, Africa Israel Residences Ltd (TLV:AFRE) does carry debt. But the real question is whether this debt is making the company risky.

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Africa Israel Residences

What Is Africa Israel Residences's Net Debt?

The image below, which you can click on for greater detail, shows that Africa Israel Residences had debt of ₪2.13b at the end of September 2021, a reduction from ₪2.24b over a year. However, it also had ₪362.8m in cash, and so its net debt is ₪1.77b.

How Strong Is Africa Israel Residences' Balance Sheet?

According to the last reported balance sheet, Africa Israel Residences had liabilities of ₪1.37b due within 12 months, and liabilities of ₪1.16b due beyond 12 months. Offsetting this, it had ₪362.8m in cash and ₪472.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₪1.70b.

This deficit is considerable relative to its market capitalization of ₪2.67b, so it does suggest shareholders should keep an eye on Africa Israel Residences' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Africa Israel Residences has a rather high debt to EBITDA ratio of 11.3 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 4.2 times, suggesting it can responsibly service its obligations. Notably, Africa Israel Residences's EBIT was pretty flat over the last year, which isn't ideal given the debt load. When analysing debt levels, the balance sheet is the obvious place to start. But it is Africa Israel Residences's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Africa Israel Residences generated free cash flow amounting to a very robust 93% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Neither Africa Israel Residences's ability handle its debt, based on its EBITDA, nor its level of total liabilities gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Africa Israel Residences is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. We've identified 5 warning signs with Africa Israel Residences (at least 2 which don't sit too well with us) , and understanding them should be part of your investment process.

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.