Harvey Norman Holdings (ASX:HVN) Seems To Use Debt Quite Sensibly

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. As with many other companies Harvey Norman Holdings Limited (ASX:HVN) makes use of debt. But the real question is whether this debt is making the company risky.

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Harvey Norman Holdings

How Much Debt Does Harvey Norman Holdings Carry?

As you can see below, at the end of June 2024, Harvey Norman Holdings had AU$944.6m of debt, up from AU$850.4m a year ago. Click the image for more detail. However, it does have AU$273.5m in cash offsetting this, leading to net debt of about AU$671.1m.

How Strong Is Harvey Norman Holdings' Balance Sheet?

According to the last reported balance sheet, Harvey Norman Holdings had liabilities of AU$796.2m due within 12 months, and liabilities of AU$2.59b due beyond 12 months. Offsetting these obligations, it had cash of AU$273.5m as well as receivables valued at AU$941.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$2.18b.

This deficit isn't so bad because Harvey Norman Holdings is worth AU$5.74b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Harvey Norman Holdings's net debt is only 0.91 times its EBITDA. And its EBIT easily covers its interest expense, being 11.1 times the size. So we're pretty relaxed about its super-conservative use of debt. But the bad news is that Harvey Norman Holdings has seen its EBIT plunge 17% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Harvey Norman 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Harvey Norman Holdings produced sturdy free cash flow equating to 60% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

When it comes to the balance sheet, the standout positive for Harvey Norman Holdings was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. In particular, EBIT growth rate gives us cold feet. Looking at all this data makes us feel a little cautious about Harvey Norman Holdings's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. To that end, you should be aware of the 2 warning signs we've spotted with Harvey Norman Holdings .

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. 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.