Overseas Commerce (TLV:OVRS) Seems To Use Debt Quite Sensibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Overseas Commerce Ltd. (TLV:OVRS) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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.

View our latest analysis for Overseas Commerce

What Is Overseas Commerce's Debt?

As you can see below, Overseas Commerce had ₪129.5m of debt at September 2020, down from ₪148.5m a year prior. However, it also had ₪10.3m in cash, and so its net debt is ₪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 outweigh the sum of its cash and (near-term) receivables by ₪345.2m.

When you consider that this deficiency exceeds the company's ₪241.1m 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.

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). 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).

Even though Overseas Commerce's debt is only 1.9, its interest cover is really very low at 2.4. This does have us wondering if the company pays high interest because it is considered risky. Either way there's no doubt the stock is using meaningful leverage. Also relevant is that Overseas Commerce has grown its EBIT by a very respectable 26% 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 Overseas Commerce 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Overseas Commerce actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Both Overseas Commerce's ability to to convert EBIT to free cash flow and its EBIT growth rate gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to handle its total liabilities. We would also note that Infrastructure industry companies like Overseas Commerce commonly do use debt without problems. Looking at all this data makes us feel a little cautious about Overseas Commerce'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. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Like risks, for instance. Every company has them, and we've spotted 5 warning signs for Overseas Commerce (of which 2 don't sit too well with us!) you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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