Arad (TLV:ARD) Seems To Use Debt Quite Sensibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, Arad Ltd. (TLV:ARD) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Arad

What Is Arad's Debt?

You can click the graphic below for the historical numbers, but it shows that Arad had US$54.2m of debt in September 2020, down from US$59.0m, one year before. However, it also had US$29.8m in cash, and so its net debt is US$24.4m.

How Strong Is Arad's Balance Sheet?

According to the last reported balance sheet, Arad had liabilities of US$94.6m due within 12 months, and liabilities of US$60.5m due beyond 12 months. On the other hand, it had cash of US$29.8m and US$71.5m worth of receivables due within a year. So it has liabilities totalling US$53.9m more than its cash and near-term receivables, combined.

Given Arad has a market capitalization of US$361.0m, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Arad has net debt of just 0.76 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 7.5 times the interest expense over the last year. On the other hand, Arad's EBIT dived 11%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Arad 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Arad's free cash flow amounted to 44% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

On our analysis Arad's net debt to EBITDA should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its EBIT growth rate makes us a little nervous about its debt. Looking at all this data makes us feel a little cautious about Arad's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for Arad that you should be aware of.

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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