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. Importantly, Naphtha Israel Petroleum Corp. Ltd. (TLV:NFTA) does carry debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
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What Is Naphtha Israel Petroleum’s Debt?
The image below, which you can click on for greater detail, shows that Naphtha Israel Petroleum had debt of ₪1.77b at the end of September 2022, a reduction from ₪2.06b over a year. However, it also had ₪905.7m in cash, and so its net debt is ₪869.2m.
A Look At Naphtha Israel Petroleum’s Liabilities
According to the last reported balance sheet, Naphtha Israel Petroleum had liabilities of ₪687.0m due within 12 months, and liabilities of ₪2.24b due beyond 12 months. Offsetting this, it had ₪905.7m in cash and ₪290.5m in receivables that were due within 12 months. So its liabilities total ₪1.74b more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company’s market capitalization of ₪1.38b, we think shareholders really should watch Naphtha Israel Petroleum’s debt levels, like a parent watching their child ride a bike for the first time. 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 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Naphtha Israel Petroleum has a low net debt to EBITDA ratio of only 0.82. And its EBIT covers its interest expense a whopping 49.0 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Another good sign is that Naphtha Israel Petroleum has been able to increase its EBIT by 20% in twelve months, making it easier 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 Naphtha Israel Petroleum 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, Naphtha Israel Petroleum actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Both Naphtha Israel Petroleum’s ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to handle its total liabilities. When we consider all the elements mentioned above, it seems to us that Naphtha Israel Petroleum is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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 2 warning signs for Naphtha Israel Petroleum that 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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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.