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. As with many other companies High Liner Foods Incorporated (TSE:HLF) makes use of debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is High Liner Foods’s Debt?
The image below, which you can click on for greater detail, shows that High Liner Foods had debt of US$341.1m at the end of December 2019, a reduction from US$367.5m over a year. Net debt is about the same, since the it doesn’t have much cash.
How Healthy Is High Liner Foods’s Balance Sheet?
We can see from the most recent balance sheet that High Liner Foods had liabilities of US$209.6m falling due within a year, and liabilities of US$342.7m due beyond that. Offsetting this, it had US$3.38m in cash and US$88.6m in receivables that were due within 12 months. So its liabilities total US$460.4m more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the US$188.3m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, High Liner Foods would probably need a major re-capitalization if its creditors were to demand repayment.
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). 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 cover ratio).
Weak interest cover of 2.3 times and a disturbingly high net debt to EBITDA ratio of 5.0 hit our confidence in High Liner Foods like a one-two punch to the gut. The debt burden here is substantial. However, one redeeming factor is that High Liner Foods grew its EBIT at 16% over the last 12 months, boosting its ability to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine High Liner Foods’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
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 look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, High Liner Foods recorded free cash flow of 30% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
On the face of it, High Liner Foods’s net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at growing its EBIT; that’s encouraging. Overall, it seems to us that High Liner Foods’s balance sheet is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. Be aware that High Liner Foods is showing 4 warning signs in our investment analysis , and 1 of those is potentially serious…
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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