Is Hills (ASX:HIL) 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.' 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 Hills Limited (ASX:HIL) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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.

See our latest analysis for Hills

What Is Hills's Net Debt?

As you can see below, Hills had AU$6.50m of debt at December 2022, down from AU$20.3m a year prior. However, it also had AU$1.57m in cash, and so its net debt is AU$4.93m.

How Strong Is Hills' Balance Sheet?

We can see from the most recent balance sheet that Hills had liabilities of AU$20.2m falling due within a year, and liabilities of AU$3.43m due beyond that. Offsetting these obligations, it had cash of AU$1.57m as well as receivables valued at AU$10.4m due within 12 months. So its liabilities total AU$11.7m more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of AU$12.6m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Hills's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

In the last year Hills managed to produce its first revenue as a listed company, but given the lack of profit, shareholders will no doubt be hoping to see some strong increases.

Caveat Emptor

Importantly, Hills had an earnings before interest and tax (EBIT) loss over the last year. Its EBIT loss was a whopping AU$5.9m. 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. So we think its balance sheet is a little strained, though not beyond repair. Another cause for caution is that is bled AU$6.0m in negative free cash flow over the last twelve months. So suffice it to say we consider the stock very risky. 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 5 warning signs we've spotted with Hills .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.