Howard Marks put it well when he said that, rather than worrying about stock price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ It is only natural to consider a company’s balance sheet when examining how risky it is, as debt is often involved when a business collapses. We take note of that Electra Property Ltd. (TLV:ELCRE) does have debt on its balance sheet. But the real question is whether this debt makes the company risky.
When is debt dangerous?
Debt helps a business until the business struggles to pay it off, either with new capital or with free cash flow. If things go really bad, the lenders can take control of the business. However, a more frequent (but still more expensive) occurrence is where a company must issue shares at bargain basement prices, permanently diluting shareholders, just to bolster its balance sheet. However, by replacing dilution, debt can be an extremely good tool for companies that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
Look at the opportunities and risks within the IL Real Estate industry.
What is Electra Real Estate’s net debt?
You can click on the chart below for the historical figures, but it shows that as of June 2022, Electra Real Estate had US$238.0m in debt, an increase of US$190.4m, over one year. However, because it has a cash reserve of US$28.9m, its net debt is less, at around US$209.1m.
A look at Electra Real Estate’s liabilities
According to the last reported balance sheet, Electra Real Estate has liabilities of US$89.8m due within 12 months, and liabilities of US$260.2m due after 12 months. To offset these liabilities, it had cash of US$28.9m as well as receivables worth US$47.1m due within 12 months. It therefore has liabilities totaling US$273.9 million more than its cash and short-term debtors combined.
Electra Real Estate has a market cap of US$765.8 million, so it can most likely raise cash to improve its balance sheet, should the need arise. But we certainly want to keep our eyes open for indications that his debt is too much of a risk.
To measure a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its interest expense ( its interest coverage). 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 coverage ratio).
Electra Real Estate’s net debt is only 0.71 times its EBITDA. And its EBIT covers its interest costs a whopping 173 times more. So we’re pretty relaxed about the super-conservative use of debt. Better yet, Electra Real Estate grew its EBIT by 306% last year, which is an impressive improvement. This boost will make it even easier to pay off debt in the future. There is no doubt that we learn the most about debt from the balance sheet. But it is Electra Real Estate’s earnings that will affect how the balance sheet holds up in the future. So when you’re considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive screenshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to see if that EBIT leads to corresponding free cash flow. In the last three years, Electra Real Estate has generated free cash flow amounting to 14% of its EBIT, an uninspiring performance. For us, cash conversion that sparks a little paranoia about is the ability to pay off debt.
The good news is that Electra Real Estate’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But in truth, we feel that converting EBIT to free cash flow undermines this impression a bit. All these things considered, it appears that Electra Real Estate can handle its current debt levels comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. The balance sheet is clearly the area you should focus on when analyzing debt. However, not all investment risks lie within the balance sheet – far from it. For example, we discovered 3 warning signs for Electra Real Estate (2 is potentially serious!) that you should be aware of before investing here.
At the end of the day, it is often better to focus on companies that are free of net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
Valuation is complex, but we help make it simple.
Find out if Electra Property may be over or undervalued by looking at our comprehensive analysis, which includes fair value estimates, risks and caveats, dividends, insider trading and financial health.
Check out the free analysis
Do you have feedback on this article? Worried about the content? Contact me directly with us. Alternatively, email editorial team (at) simplywallst.com.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell any stock, and does not take into account your goals or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any listed stocks.