Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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. As with many other companies HRL Holdings Limited (ASX:HRL) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is HRL Holdings’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2019 HRL Holdings had AU$3.56m of debt, an increase on AU$10.0, over one year. However, it does have AU$1.26m in cash offsetting this, leading to net debt of about AU$2.31m.
How Healthy Is HRL Holdings’s Balance Sheet?
We can see from the most recent balance sheet that HRL Holdings had liabilities of AU$7.78m falling due within a year, and liabilities of AU$2.64m due beyond that. On the other hand, it had cash of AU$1.26m and AU$3.84m worth of receivables due within a year. So its liabilities total AU$5.32m more than the combination of its cash and short-term receivables.
Since publicly traded HRL Holdings shares are worth a total of AU$59.2m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse.
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).
HRL Holdings has a very low debt to EBITDA ratio of 0.58 so it is strange to see weak interest coverage, with last year’s EBIT being only 2.3 times the interest expense. So one way or the other, it’s clear the debt levels are not trivial. We also note that HRL Holdings improved its EBIT from a last year’s loss to a positive AU$727k. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if HRL 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 is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, HRL Holdings 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.
HRL Holdings’s struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. In particular, its net debt to EBITDA was re-invigorating. When we consider all the factors discussed, it seems to us that HRL Holdings is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. For example, we’ve discovered 3 warning signs for HRL Holdings that you should be aware of before investing here.
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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