Is Castro Model (TLV:CAST) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Castro Model Ltd. (TLV:CAST) makes use of debt. But is this debt a concern to shareholders?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Castro Model

How Much Debt Does Castro Model Carry?

The image below, which you can click on for greater detail, shows that at December 2020 Castro Model had debt of ₪321.3m, up from ₪285.9m in one year. However, its balance sheet shows it holds ₪349.4m in cash, so it actually has ₪28.1m net cash.

How Strong Is Castro Model's Balance Sheet?

The latest balance sheet data shows that Castro Model had liabilities of ₪439.0m due within a year, and liabilities of ₪1.08b falling due after that. On the other hand, it had cash of ₪349.4m and ₪79.3m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₪1.09b.

The deficiency here weighs heavily on the ₪692.6m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Castro Model would probably need a major re-capitalization if its creditors were to demand repayment. Castro Model boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

We also note that Castro Model improved its EBIT from a last year's loss to a positive ₪62m. 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 Castro Model 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Castro Model may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last year, Castro Model actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

While Castro Model does have more liabilities than liquid assets, it also has net cash of ₪28.1m. The cherry on top was that in converted 180% of that EBIT to free cash flow, bringing in ₪112m. So while Castro Model does not have a great balance sheet, it's certainly not too bad. 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 Castro Model (2 can't be ignored!) that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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