Here's Why Health and Plant Protein Group (ASX:HPP) Has A Meaningful Debt Burden

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Health and Plant Protein Group Limited (ASX:HPP) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Health and Plant Protein Group

What Is Health and Plant Protein Group's Debt?

You can click the graphic below for the historical numbers, but it shows that Health and Plant Protein Group had AU$16.0m of debt in December 2021, down from AU$22.5m, one year before. However, it does have AU$2.82m in cash offsetting this, leading to net debt of about AU$13.2m.

A Look At Health and Plant Protein Group's Liabilities

Zooming in on the latest balance sheet data, we can see that Health and Plant Protein Group had liabilities of AU$7.39m due within 12 months and liabilities of AU$22.1m due beyond that. Offsetting these obligations, it had cash of AU$2.82m as well as receivables valued at AU$2.03m due within 12 months. So its liabilities total AU$24.7m more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the AU$16.0m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Health and Plant Protein Group 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).

Health and Plant Protein Group's net debt is sitting at a very reasonable 2.4 times its EBITDA, while its EBIT covered its interest expense just 2.9 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. However, the silver lining was that Health and Plant Protein Group achieved a positive EBIT of AU$4.4m in the last twelve months, an improvement on the prior year's loss. There's no doubt that we learn most about debt from the balance sheet. But it is Health and Plant Protein Group'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, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the most recent year, Health and Plant Protein Group recorded free cash flow worth 67% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Mulling over Health and Plant Protein Group's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the bigger picture, it seems clear to us that Health and Plant Protein Group's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Health and Plant Protein Group that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.