Does Hammond Manufacturing (TSE:HMM.A) Have A Healthy Balance Sheet?

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 can see that Hammond Manufacturing Company Limited (TSE:HMM.A) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Hammond Manufacturing

How Much Debt Does Hammond Manufacturing Carry?

As you can see below, Hammond Manufacturing had CA$21.1m of debt at September 2020, down from CA$26.0m a year prior. However, because it has a cash reserve of CA$1.08m, its net debt is less, at about CA$20.0m.

How Strong Is Hammond Manufacturing's Balance Sheet?

The latest balance sheet data shows that Hammond Manufacturing had liabilities of CA$38.6m due within a year, and liabilities of CA$17.3m falling due after that. Offsetting these obligations, it had cash of CA$1.08m as well as receivables valued at CA$20.2m due within 12 months. So it has liabilities totalling CA$34.6m more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's CA$25.3m market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Hammond Manufacturing has net debt worth 1.8 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 5.1 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Notably Hammond Manufacturing's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Hammond Manufacturing 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Hammond Manufacturing recorded free cash flow of 22% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

We'd go so far as to say Hammond Manufacturing's level of total liabilities was disappointing. But at least its net debt to EBITDA is not so bad. Overall, we think it's fair to say that Hammond Manufacturing has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Hammond Manufacturing you should be aware of.

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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