Here's Why Zvi Sarfati & Sons Investments & Constructions (TLV:SRFT) Is Weighed Down By Its Debt Load

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 can see that Zvi Sarfati & Sons Investments & Constructions Ltd. (TLV:SRFT) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, 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.

View our latest analysis for Zvi Sarfati & Sons Investments & Constructions

How Much Debt Does Zvi Sarfati & Sons Investments & Constructions Carry?

The image below, which you can click on for greater detail, shows that at September 2020 Zvi Sarfati & Sons Investments & Constructions had debt of ₪509.0m, up from ₪450.3m in one year. However, it also had ₪93.2m in cash, and so its net debt is ₪415.8m.

How Strong Is Zvi Sarfati & Sons Investments & Constructions' Balance Sheet?

According to the last reported balance sheet, Zvi Sarfati & Sons Investments & Constructions had liabilities of ₪514.1m due within 12 months, and liabilities of ₪97.3m due beyond 12 months. On the other hand, it had cash of ₪93.2m and ₪32.8m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₪485.5m.

When you consider that this deficiency exceeds the company's ₪323.8m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 1.6 times and a disturbingly high net debt to EBITDA ratio of 14.3 hit our confidence in Zvi Sarfati & Sons Investments & Constructions like a one-two punch to the gut. The debt burden here is substantial. Even more troubling is the fact that Zvi Sarfati & Sons Investments & Constructions actually let its EBIT decrease by 5.8% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. There's no doubt that we learn most about debt from the balance sheet. But it is Zvi Sarfati & Sons Investments & Constructions'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.

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. During the last three years, Zvi Sarfati & Sons Investments & Constructions burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Zvi Sarfati & Sons Investments & Constructions's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its interest cover also fails to instill confidence. We think the chances that Zvi Sarfati & Sons Investments & Constructions has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. 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. For example, we've discovered 3 warning signs for Zvi Sarfati & Sons Investments & Constructions (1 is concerning!) that you should be aware of before investing here.

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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