These 4 Measures Indicate That Delek Automotive Systems (TLV:DLEA) Is Using Debt Reasonably Well

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.' 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 Delek Automotive Systems Ltd. (TLV:DLEA) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Delek Automotive Systems

How Much Debt Does Delek Automotive Systems Carry?

The image below, which you can click on for greater detail, shows that at September 2020 Delek Automotive Systems had debt of ₪2.65b, up from ₪2.52b in one year. However, because it has a cash reserve of ₪193.5m, its net debt is less, at about ₪2.46b.

A Look At Delek Automotive Systems' Liabilities

Zooming in on the latest balance sheet data, we can see that Delek Automotive Systems had liabilities of ₪2.23b due within 12 months and liabilities of ₪1.46b due beyond that. Offsetting these obligations, it had cash of ₪193.5m as well as receivables valued at ₪817.8m due within 12 months. So its liabilities total ₪2.67b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of ₪3.11b, 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 use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Delek Automotive Systems's net debt is 4.9 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 23.1 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. If Delek Automotive Systems can keep growing EBIT at last year's rate of 18% over the last year, then it will find its debt load easier to manage. There's no doubt that we learn most about debt from the balance sheet. But it is Delek Automotive Systems'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Delek Automotive Systems produced sturdy free cash flow equating to 73% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Both Delek Automotive Systems's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle handle its debt, based on its EBITDA,. When we consider all the elements mentioned above, it seems to us that Delek Automotive Systems is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Delek Automotive Systems (of which 2 are potentially serious!) you should know about.

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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