Is Africa Israel Residences (TLV:AFRE) Using Too Much Debt?

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. As with many other companies Africa Israel Residences Ltd (TLV:AFRE) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Africa Israel Residences

How Much Debt Does Africa Israel Residences Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Africa Israel Residences had ₪2.24b of debt, an increase on ₪1.86b, over one year. However, it also had ₪318.2m in cash, and so its net debt is ₪1.92b.

How Strong Is Africa Israel Residences' Balance Sheet?

We can see from the most recent balance sheet that Africa Israel Residences had liabilities of ₪1.49b falling due within a year, and liabilities of ₪1.23b due beyond that. Offsetting this, it had ₪318.2m in cash and ₪583.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₪1.82b.

This is a mountain of leverage relative to its market capitalization of ₪2.09b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

Africa Israel Residences has a rather high debt to EBITDA ratio of 13.6 which suggests a meaningful debt load. However, its interest coverage of 3.8 is reasonably strong, which is a good sign. More concerning, Africa Israel Residences saw its EBIT drop by 4.5% in the last twelve months. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. The balance sheet is clearly the area to focus on when you are analysing debt. 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 always check how much of that EBIT is translated into free cash flow. During the last three years, Africa Israel Residences produced sturdy free cash flow equating to 53% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

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. Overall, we think it's fair to say that Africa Israel Residences has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 4 warning signs for Africa Israel Residences (2 can't be ignored) you should be aware of.

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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