Here's Why Overseas Commerce (TLV:OVRS) Can Manage Its Debt Responsibly

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 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. We note that Overseas Commerce Ltd. (TLV:OVRS) does have debt on its balance sheet. 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Overseas Commerce

How Much Debt Does Overseas Commerce Carry?

The image below, which you can click on for greater detail, shows that Overseas Commerce had debt of ₪129.5m at the end of September 2020, a reduction from ₪148.5m over a year. However, because it has a cash reserve of ₪10.3m, its net debt is less, at about ₪119.2m.

A Look At Overseas Commerce's Liabilities

The latest balance sheet data shows that Overseas Commerce had liabilities of ₪128.6m due within a year, and liabilities of ₪304.8m falling due after that. On the other hand, it had cash of ₪10.3m and ₪78.0m worth of receivables due within a year. So its liabilities total ₪345.2m more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's ₪234.1m market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Overseas Commerce has a quite reasonable net debt to EBITDA multiple of 1.9, its interest cover seems weak, at 2.4. This does suggest the company is paying fairly high interest rates. Either way there's no doubt the stock is using meaningful leverage. We note that Overseas Commerce grew its EBIT by 26% in the last year, and that should make it easier to pay down debt, going forward. 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 Overseas Commerce will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Overseas Commerce actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Overseas Commerce's conversion of EBIT to free cash flow was a real positive on this analysis, as was its EBIT growth rate. But truth be told its level of total liabilities had us nibbling our nails. It's also worth noting that Overseas Commerce is in the Infrastructure industry, which is often considered to be quite defensive. Looking at all this data makes us feel a little cautious about Overseas Commerce'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. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 4 warning signs for Overseas Commerce (2 are a bit concerning!) that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. 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.
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