Is Arad Investment & Industrial Development (TLV:ARAD) A Risky Investment?

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 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. Importantly, Arad Investment & Industrial Development Ltd. (TLV:ARAD) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Arad Investment & Industrial Development

What Is Arad Investment & Industrial Development's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Arad Investment & Industrial Development had ₪696.2m of debt in June 2024, down from ₪4.13b, one year before. However, because it has a cash reserve of ₪348.5m, its net debt is less, at about ₪347.7m.

How Healthy Is Arad Investment & Industrial Development's Balance Sheet?

According to the last reported balance sheet, Arad Investment & Industrial Development had liabilities of ₪974.0m due within 12 months, and liabilities of ₪749.0m due beyond 12 months. On the other hand, it had cash of ₪348.5m and ₪979.3m worth of receivables due within a year. So its liabilities total ₪395.3m more than the combination of its cash and short-term receivables.

Arad Investment & Industrial Development has a market capitalization of ₪722.7m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Arad Investment & Industrial Development has a quite reasonable net debt to EBITDA multiple of 1.5, its interest cover seems weak, at 2.2. This does suggest the company is paying fairly high interest rates. In any case, it's safe to say the company has meaningful debt. We also note that Arad Investment & Industrial Development improved its EBIT from a last year's loss to a positive ₪167m. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Arad Investment & Industrial Development 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, Arad Investment & Industrial Development actually produced more free cash flow than EBIT over the last year. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

When it comes to the balance sheet, the standout positive for Arad Investment & Industrial Development was the fact that it seems able to convert EBIT to free cash flow confidently. But the other factors we noted above weren't so encouraging. In particular, interest cover gives us cold feet. Looking at all this data makes us feel a little cautious about Arad Investment & Industrial Development'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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Arad Investment & Industrial Development , and understanding them should be part of your investment process.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.