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. 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. We note that HRL Holdings Limited (ASX:HRL) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.
What Is HRL Holdings’s Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 HRL Holdings had debt of AU$2.86m, up from AU$1.11m in one year. On the flip side, it has AU$1.03m in cash leading to net debt of about AU$1.83m.
How Healthy Is HRL Holdings’s Balance Sheet?
According to the last reported balance sheet, HRL Holdings had liabilities of AU$6.63m due within 12 months, and liabilities of AU$2.46m due beyond 12 months. Offsetting these obligations, it had cash of AU$1.03m as well as receivables valued at AU$4.99m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$3.07m.
Of course, HRL Holdings has a market capitalization of AU$54.3m, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. When analysing debt levels, the balance sheet is the obvious place to start. 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.
Over 12 months, HRL Holdings reported revenue of AU$31m, which is a gain of 13%, although it did not report any earnings before interest and tax. We usually like to see faster growth from unprofitable companies, but each to their own.
Over the last twelve months HRL Holdings produced an earnings before interest and tax (EBIT) loss. To be specific the EBIT loss came in at AU$1.8m. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Another cause for caution is that is bled AU$6.3m in negative free cash flow over the last twelve months. So suffice it to say we consider the stock very risky. For riskier companies like HRL Holdings I always like to keep an eye on whether insiders are buying or selling. So click here if you want to find out for yourself.
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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If you spot an error that warrants correction, please contact the editor at email@example.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. Thank you for reading.