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.' 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 can see that OPC Energy Ltd. (TLV:OPCE) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does OPC Energy Carry?
The image below, which you can click on for greater detail, shows that at March 2021 OPC Energy had debt of ₪3.51b, up from ₪2.35b in one year. On the flip side, it has ₪850.0m in cash leading to net debt of about ₪2.66b.
How Strong Is OPC Energy's Balance Sheet?
We can see from the most recent balance sheet that OPC Energy had liabilities of ₪758.0m falling due within a year, and liabilities of ₪3.86b due beyond that. On the other hand, it had cash of ₪850.0m and ₪240.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₪3.53b.
This deficit is considerable relative to its market capitalization of ₪5.77b, so it does suggest shareholders should keep an eye on OPC Energy's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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.
OPC Energy shareholders face the double whammy of a high net debt to EBITDA ratio (9.3), and fairly weak interest coverage, since EBIT is just 1.9 times the interest expense. The debt burden here is substantial. Worse, OPC Energy's EBIT was down 30% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But it is OPC Energy's earnings that will influence how the balance sheet holds up in the future. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, OPC Energy recorded free cash flow worth 52% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
On the face of it, OPC Energy's net debt to EBITDA left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its conversion of EBIT to free cash flow is not so bad. Overall, it seems to us that OPC Energy's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For instance, we've identified 3 warning signs for OPC Energy (2 are concerning) you should be aware of.
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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