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 can see that Ormat Technologies, Inc. (NYSE:ORA) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Ormat Technologies's Net Debt?
As you can see below, at the end of December 2020, Ormat Technologies had US$1.46b of debt, up from US$1.24b a year ago. Click the image for more detail. However, it also had US$448.3m in cash, and so its net debt is US$1.01b.
How Strong Is Ormat Technologies' Balance Sheet?
The latest balance sheet data shows that Ormat Technologies had liabilities of US$248.6m due within a year, and liabilities of US$1.69b falling due after that. Offsetting these obligations, it had cash of US$448.3m as well as receivables valued at US$191.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.30b.
This deficit isn't so bad because Ormat Technologies is worth US$5.06b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
Ormat Technologies has a debt to EBITDA ratio of 2.9 and its EBIT covered its interest expense 2.5 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Given the debt load, it's hardly ideal that Ormat Technologies's EBIT was pretty flat over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Ormat Technologies can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Ormat Technologies burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Mulling over Ormat Technologies's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. Having said that, its ability to handle its total liabilities isn't such a worry. Once we consider all the factors above, together, it seems to us that Ormat Technologies's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for Ormat Technologies (2 are a bit unpleasant) 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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