Here's Why Delek Automotive Systems (TLV:DLEA) Can Manage Its Debt Responsibly

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Delek Automotive Systems Ltd. (TLV:DLEA) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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. 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.

View our latest analysis for Delek Automotive Systems

How Much Debt Does Delek Automotive Systems Carry?

As you can see below, Delek Automotive Systems had ₪2.51b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, it also had ₪110.9m in cash, and so its net debt is ₪2.40b.

How Strong Is Delek Automotive Systems' Balance Sheet?

We can see from the most recent balance sheet that Delek Automotive Systems had liabilities of ₪2.52b falling due within a year, and liabilities of ₪1.59b due beyond that. Offsetting this, it had ₪110.9m in cash and ₪616.3m in receivables that were due within 12 months. So its liabilities total ₪3.38b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of ₪3.70b, so it does suggest shareholders should keep an eye on Delek Automotive Systems' use of debt. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Delek Automotive Systems has net debt to EBITDA of 4.6 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 7.0 suggests it can easily service that debt. Also relevant is that Delek Automotive Systems has grown its EBIT by a very respectable 20% in the last year, thus enhancing its ability to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Delek Automotive Systems 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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Delek Automotive Systems recorded free cash flow worth 74% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Delek Automotive Systems's conversion of EBIT to free cash flow was a real positive on this analysis, as was its EBIT growth rate. In contrast, our confidence was undermined by its apparent struggle handle its debt, based on its EBITDA,. Looking at all this data makes us feel a little cautious about Delek Automotive Systems's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. Case in point: We've spotted 3 warning signs for Delek Automotive Systems you should be aware of, and 2 of them make us uncomfortable.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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