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.' 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. Importantly, Hills Limited (ASX:HIL) does carry debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Hills's Debt?
You can click the graphic below for the historical numbers, but it shows that Hills had AU$23.1m of debt in December 2020, down from AU$29.4m, one year before. However, because it has a cash reserve of AU$11.7m, its net debt is less, at about AU$11.3m.
A Look At Hills' Liabilities
According to the last reported balance sheet, Hills had liabilities of AU$43.0m due within 12 months, and liabilities of AU$28.9m due beyond 12 months. On the other hand, it had cash of AU$11.7m and AU$34.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$25.7m.
This deficit is considerable relative to its market capitalization of AU$36.0m, so it does suggest shareholders should keep an eye on Hills' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Hills will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Over 12 months, Hills made a loss at the EBIT level, and saw its revenue drop to AU$187m, which is a fall of 29%. That makes us nervous, to say the least.
While Hills's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost AU$1.5m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. We would feel better if it turned its trailing twelve month loss of AU$15m into a profit. So in short it's a really risky stock. 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. We've identified 1 warning sign with Hills , and understanding them should be part of your investment process.
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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