These 4 Measures Indicate That Harvey Norman Holdings (ASX:HVN) Is Using Debt Safely

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.' 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 Harvey Norman Holdings Limited (ASX:HVN) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. 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. 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

How Much Debt Does Harvey Norman Holdings Carry?

The image below, which you can click on for greater detail, shows that at June 2021 Harvey Norman Holdings had debt of AU$560.0m, up from AU$297.8m in one year. On the flip side, it has AU$305.7m in cash leading to net debt of about AU$254.3m.

How Healthy Is Harvey Norman Holdings' Balance Sheet?

The latest balance sheet data shows that Harvey Norman Holdings had liabilities of AU$1.15b due within a year, and liabilities of AU$1.63b falling due after that. Offsetting this, it had AU$305.7m in cash and AU$889.2m in receivables that were due within 12 months. So its liabilities total AU$1.59b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Harvey Norman Holdings has a market capitalization of AU$6.29b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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 0.21. And its EBIT covers its interest expense a whopping 55.8 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we're happy to report that Harvey Norman Holdings has boosted its EBIT by 56%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. 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 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. Over the most recent three years, Harvey Norman Holdings recorded free cash flow worth 73% 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

Happily, Harvey Norman Holdings's impressive interest cover implies it has the upper hand on its debt. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Overall, we don't think Harvey Norman Holdings is taking any bad risks, as its debt load seems modest. So the balance sheet looks pretty healthy, to us. 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. Case in point: We've spotted 2 warning signs for Harvey Norman Holdings you should be aware of, and 1 of them doesn't sit too well with us.

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.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.