The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, The Hour Glass Limited (SGX:AGS) does carry debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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 Hour Glass’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2020 Hour Glass had S$64.5m of debt, an increase on S$15.0m, over one year. But it also has S$185.3m in cash to offset that, meaning it has S$120.8m net cash.
A Look At Hour Glass’s Liabilities
According to the last reported balance sheet, Hour Glass had liabilities of S$151.2m due within 12 months, and liabilities of S$82.4m due beyond 12 months. Offsetting this, it had S$185.3m in cash and S$18.2m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by S$30.1m.
Given Hour Glass has a market capitalization of S$478.7m, it’s hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Hour Glass boasts net cash, so it’s fair to say it does not have a heavy debt load!
And we also note warmly that Hour Glass grew its EBIT by 10% last year, making its debt load easier to handle. There’s no doubt that we learn most about debt from the balance sheet. But it is Hour Glass’s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Hour Glass has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Hour Glass recorded free cash flow worth a fulsome 92% of its EBIT, which is stronger than we’d usually expect. That puts it in a very strong position to pay down debt.
While it is always sensible to look at a company’s total liabilities, it is very reassuring that Hour Glass has S$120.8m in net cash. The cherry on top was that in converted 92% of that EBIT to free cash flow, bringing in S$94m. So is Hour Glass’s debt a risk? It doesn’t seem so to us. 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. Case in point: We’ve spotted 1 warning sign for Hour Glass you should be aware of.
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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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. 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.
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