Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ 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. As with many other companies Mega Or Holdings Ltd (TLV:MGOR) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.
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What Is Mega Or Holdings’s Net Debt?
As you can see below, at the end of September 2022, Mega Or Holdings had ₪4.37b of debt, up from ₪3.56ba year ago. Click the image for more details. However, it does have ₪559.5m in cash offsetting this, leading to net debt of about ₪3.81b.
A Look At Mega Or Holdings’ Liabilities
According to the last reported balance sheet, Mega Or Holdings had liabilities of ₪673.1m due within 12 months, and liabilities of ₪4.10b due beyond 12 months. On the other hand, it had cash of ₪559.5m and ₪48.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₪4.17b.
Given this deficit is actually higher than the company’s market capitalization of ₪3.44b, we think shareholders really should watch Mega Or Holdings’s debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
As it happens Mega Or Holdings has a fairly concerning net debt to EBITDA ratio of 6.1 but very strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Notably, Mega Or Holdings’s EBIT launched higher than Elon Musk, gaining a whopping 136% on last year. The balance sheet is clearly the area to focus on when you are analyzing debt. But you can’t view debt in total isolation; since Mega Or Holdings 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, while the taxman may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Mega Or Holdings created free cash flow amounting to 13% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
While Mega Or Holdings’s net debt to EBITDA has us nervous. To wit both its interest cover and EBIT growth rate were encouraging signs. Taking the above-mentioned factors together we do think Mega Or Holdings’s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analyzing debt. However, not all investment risk resides within the balance sheet – far from it. Be aware that Mega Or Holdings is showing 4 warning signs in our investment analysis and 1 of those is significant…
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% freeright now.
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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 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.