Here's Why Hammond Manufacturing (TSE:HMM.A) Has A Meaningful Debt Burden

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 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?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out 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. On the other hand, it had cash of CA$1.08m and CA$20.2m worth of receivables due within a year. So it has liabilities totalling CA$34.6m more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CA$21.5m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Hammond Manufacturing would likely require a major re-capitalisation if it had to pay its creditors today.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Hammond Manufacturing's net debt is sitting at a very reasonable 1.8 times its EBITDA, while its EBIT covered its interest expense just 5.1 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Notably Hammond Manufacturing's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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 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 weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over Hammond Manufacturing's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least its net debt to EBITDA is not so bad. Overall, it seems to us that Hammond Manufacturing's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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