Does Harvey Norman Holdings (ASX:HVN) Have A Healthy Balance Sheet?

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Harvey Norman Holdings Limited (ASX:HVN) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. 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.

See our latest analysis for Harvey Norman Holdings

What Is Harvey Norman Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that Harvey Norman Holdings had AU$297.8m of debt in June 2020, down from AU$838.0m, one year before. However, its balance sheet shows it holds AU$343.4m in cash, so it actually has AU$45.6m net cash.

A Look At Harvey Norman Holdings's Liabilities

Zooming in on the latest balance sheet data, we can see that Harvey Norman Holdings had liabilities of AU$785.4m due within 12 months and liabilities of AU$1.57b due beyond that. Offsetting these obligations, it had cash of AU$343.4m as well as receivables valued at AU$511.6m due within 12 months. So it has liabilities totalling AU$1.50b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Harvey Norman Holdings has a market capitalization of AU$5.88b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. While it does have liabilities worth noting, Harvey Norman Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.

In addition to that, we're happy to report that Harvey Norman Holdings has boosted its EBIT by 53%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Harvey Norman Holdings's ability to maintain a healthy balance sheet going forward. 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. While Harvey Norman Holdings 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. During the last three years, Harvey Norman Holdings generated free cash flow amounting to a very robust 98% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing up

Although Harvey Norman Holdings's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$45.6m. The cherry on top was that in converted 98% of that EBIT to free cash flow, bringing in AU$963m. So we don't think Harvey Norman Holdings's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Like risks, for instance. Every company has them, and we've spotted 2 warning signs for Harvey Norman Holdings (of which 1 is significant!) you should know about.

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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