Is Africa Israel Residences (TLV:AFRE) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 note that Africa Israel Residences Ltd (TLV:AFRE) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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 Africa Israel Residences

What Is Africa Israel Residences's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2021 Africa Israel Residences had debt of ₪2.48b, up from ₪1.97b in one year. On the flip side, it has ₪601.9m in cash leading to net debt of about ₪1.88b.

How Healthy Is Africa Israel Residences' Balance Sheet?

We can see from the most recent balance sheet that Africa Israel Residences had liabilities of ₪1.67b falling due within a year, and liabilities of ₪1.20b due beyond that. Offsetting these obligations, it had cash of ₪601.9m as well as receivables valued at ₪475.3m due within 12 months. So it has liabilities totalling ₪1.78b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of ₪2.40b, so it does suggest shareholders should keep an eye on Africa Israel Residences' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Africa Israel Residences has a rather high debt to EBITDA ratio of 13.3 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 4.9 times, suggesting it can responsibly service its obligations. Sadly, Africa Israel Residences's EBIT actually dropped 4.8% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Africa Israel Residences 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Africa Israel Residences recorded free cash flow worth 56% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

We'd go so far as to say Africa Israel Residences's net debt to EBITDA was disappointing. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Africa Israel Residences'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. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Africa Israel Residences is showing 3 warning signs in our investment analysis , and 2 of those shouldn't be ignored...

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.

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.

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