Is Harvey Norman Holdings (ASX:HVN) A Risky Investment?
Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We note that Harvey Norman Holdings Limited (ASX:HVN) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
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What Is Harvey Norman Holdings's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2022 Harvey Norman Holdings had AU$879.1m of debt, an increase on AU$473.7m, over one year. However, because it has a cash reserve of AU$325.8m, its net debt is less, at about AU$553.3m.
A Look At Harvey Norman Holdings' Liabilities
We can see from the most recent balance sheet that Harvey Norman Holdings had liabilities of AU$876.1m falling due within a year, and liabilities of AU$2.47b due beyond that. Offsetting these obligations, it had cash of AU$325.8m as well as receivables valued at AU$1.11b due within 12 months. So its liabilities total AU$1.91b more than the combination of its cash and short-term receivables.
Harvey Norman Holdings has a market capitalization of AU$4.14b, so it could very likely raise cash to ameliorate 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.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Harvey Norman Holdings has a low net debt to EBITDA ratio of only 0.53. And its EBIT easily covers its interest expense, being 33.5 times the size. So we're pretty relaxed about its super-conservative use of debt. While Harvey Norman Holdings doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Harvey Norman Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Harvey Norman Holdings recorded free cash flow worth 64% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Our View
Harvey Norman Holdings's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its level of total liabilities. All these things considered, it appears that Harvey Norman Holdings can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. For example, we've discovered 2 warning signs for Harvey Norman Holdings (1 is concerning!) 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.
About ASX:HVN
Harvey Norman Holdings
Engages in the integrated retail, franchise, property, and digital system businesses.
Undervalued with excellent balance sheet and pays a dividend.