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

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Hammond Manufacturing Company Limited (TSE:HMM.A) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Hammond Manufacturing

What Is Hammond Manufacturing's Net Debt?

As you can see below, Hammond Manufacturing had CA$17.5m of debt at March 2021, down from CA$24.8m a year prior. However, it does have CA$1.03m in cash offsetting this, leading to net debt of about CA$16.5m.

A Look At Hammond Manufacturing's Liabilities

Zooming in on the latest balance sheet data, we can see that Hammond Manufacturing had liabilities of CA$36.3m due within 12 months and liabilities of CA$18.8m due beyond that. Offsetting this, it had CA$1.03m in cash and CA$23.3m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$30.7m.

This deficit is considerable relative to its market capitalization of CA$43.3m, so it does suggest shareholders should keep an eye on Hammond Manufacturing's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

With net debt sitting at just 1.1 times EBITDA, Hammond Manufacturing is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 7.5 times the interest expense over the last year. In addition to that, we're happy to report that Hammond Manufacturing has boosted its EBIT by 67%, thus reducing the spectre of future debt repayments. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Hammond Manufacturing recorded free cash flow worth 52% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

When it comes to the balance sheet, the standout positive for Hammond Manufacturing was the fact that it seems able to grow its EBIT confidently. However, our other observations weren't so heartening. For example, its level of total liabilities makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that Hammond Manufacturing is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Hammond Manufacturing you should be aware of.

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.

If you’re looking to trade a wide range of investments, open an account with the lowest-cost* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

This article by Simply Wall St is general in nature. 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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

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