David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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, HD Supply Holdings, Inc. (NASDAQ:HDS) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is HD Supply Holdings’s Net Debt?
As you can see below, at the end of November 2019, HD Supply Holdings had US$2.20b of debt, up from US$1.9k a year ago. Click the image for more detail. And it doesn’t have much cash, so its net debt is about the same.
How Healthy Is HD Supply Holdings’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that HD Supply Holdings had liabilities of US$907.0m due within 12 months and liabilities of US$2.57b due beyond that. Offsetting this, it had US$37.0m in cash and US$863.0m in receivables that were due within 12 months. So it has liabilities totalling US$2.58b more than its cash and near-term receivables, combined.
HD Supply Holdings has a market capitalization of US$6.48b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. 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.
HD Supply Holdings’s debt is 2.6 times its EBITDA, and its EBIT cover its interest expense 6.6 times over. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. We saw HD Supply Holdings grow its EBIT by 4.4% in the last twelve months. That’s far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if HD Supply Holdings can strengthen its balance sheet over time. 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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, HD Supply Holdings produced sturdy free cash flow equating to 72% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
When it comes to the balance sheet, the standout positive for HD Supply Holdings was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren’t so heartening. For example, its net debt to EBITDA makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that HD Supply Holdings is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Over time, share prices tend to follow earnings per share, so if you’re interested in HD Supply Holdings, you may well want to click here to check an interactive graph of its earnings per share history.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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