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. So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We note that Harworth Group plc (LON:HWG) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
See our latest analysis for Harworth Group
What Is Harworth Group’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2019 Harworth Group had UK£83.3m of debt, an increase on UK£73.1m, over one year. However, it also had UK£11.8m in cash, and so its net debt is UK£71.5m.
How Strong Is Harworth Group’s Balance Sheet?
We can see from the most recent balance sheet that Harworth Group had liabilities of UK£62.2m falling due within a year, and liabilities of UK£90.3m due beyond that. Offsetting this, it had UK£11.8m in cash and UK£46.5m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£94.2m.
While this might seem like a lot, it is not so bad since Harworth Group has a market capitalization of UK£311.1m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
With net debt to EBITDA of 4.7 Harworth Group has a fairly noticeable amount of debt. But the high interest coverage of 7.7 suggests it can easily service that debt. Importantly, Harworth Group grew its EBIT by 57% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Harworth Group’s ability to maintain a healthy balance sheet going forward. 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. Over the last three years, Harworth Group saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
Neither Harworth Group’s ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Harworth Group is a somewhat risky investment as a result of its debt. That’s not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 3 warning signs for Harworth Group that you should be aware of.
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% free, right now.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.