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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Hills Limited (ASX:HIL) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Hills's Debt?
As you can see below, Hills had AU$20.0m of debt, at June 2021, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has AU$6.84m in cash leading to net debt of about AU$13.2m.
A Look At Hills' Liabilities
According to the last reported balance sheet, Hills had liabilities of AU$34.1m due within 12 months, and liabilities of AU$28.0m due beyond 12 months. Offsetting this, it had AU$6.84m in cash and AU$29.8m in receivables that were due within 12 months. So its liabilities total AU$25.5m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of AU$34.8m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hills will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
In the last year Hills had a loss before interest and tax, and actually shrunk its revenue by 18%, to AU$180m. That's not what we would hope to see.
Not only did Hills's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). To be specific the EBIT loss came in at AU$2.3m. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. However, it doesn't help that it burned through AU$1.8m of cash over the last year. So suffice it to say we consider the stock very risky. There's no doubt that we learn most about debt from the balance sheet. 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.
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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