Howard Marks said 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 that every practical investor that I know is worried”. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. We can see that OPC Energy Ltd. (TLV:OPCE) uses debt in its business. But the more important question is: what risk does this debt create?
Why is debt risky?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business has is to look at its cash and debt together.
Discover our latest analysis for OPC Energy
What is OPC Energy’s net debt?
The image below, which you can click on for more details, shows that as of December 2021, OPC Energy had a debt of ₪3.76 billion, up from ₪2.95 billion in one year. However, he also had ₪760.0 million in cash, so his net debt is ₪3.00 billion.
A look at OPC Energy’s liabilities
Zooming in on the latest balance sheet data, we can see that OPC Energy had liabilities of ₪717.0 million due within 12 months and liabilities of ₪4.17 billion due beyond. On the other hand, it had a cash position of ₪760.0 million and ₪312.0 million of receivables within one year. It therefore has liabilities totaling $3.82 billion more than its cash and short-term receivables, combined.
This shortfall is not that bad as OPC Energy is worth £7.48bn and could therefore probably raise enough capital to shore up its balance sheet, should the need arise. But we definitely want to keep our eyes peeled for indications that its debt is too risky.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
A low interest coverage of 0.58x and an extremely high net debt to EBITDA ratio of 10.0 shook our confidence in OPC Energy like a punch in the gut. The debt burden here is considerable. Worse still, OPC Energy’s EBIT was down 39% from a year ago. If earnings continue to follow this trajectory, paying off that debt will be harder than convincing us to run a marathon in the rain. There is no doubt that we learn the most about debt from the balance sheet. But it is the profits of OPC Energy that will influence the balance sheet in the future. So, when considering debt, it is definitely worth looking at the earnings trend. Click here for an interactive preview.
But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, OPC Energy has barely had positive free cash flow, overall. While many businesses operate at breakeven, we’d rather see substantial free cash flow, especially if it’s already dead.
Our point of view
At first glance, OPC Energy’s interest coverage left us hesitant about the stock, and its EBIT growth rate was no more appealing than the single empty restaurant on the busiest night of the year. But at least his total passive level isn’t that bad. We are very clear that we consider OPC Energy to be really quite risky, given the health of its balance sheet. For this reason, we are quite cautious about the stock and believe shareholders should keep a close eye on its liquidity. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist outside of the balance sheet. For example, we found 3 warning signs for OPC Energy (2 are concerning!) that you should be aware of before investing here.
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.