Is Hammond Manufacturing (TSE:HMM.A) 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. We note that Hammond Manufacturing Company Limited (TSE:HMM.A) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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, at the end of December 2023, Hammond Manufacturing had CA$45.2m of debt, up from CA$36.6m a year ago. Click the image for more detail. On the flip side, it has CA$8.89m in cash leading to net debt of about CA$36.3m.

How Healthy Is Hammond Manufacturing's Balance Sheet?

We can see from the most recent balance sheet that Hammond Manufacturing had liabilities of CA$66.9m falling due within a year, and liabilities of CA$23.6m due beyond that. Offsetting this, it had CA$8.89m in cash and CA$31.7m in receivables that were due within 12 months. So its liabilities total CA$50.0m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Hammond Manufacturing has a market capitalization of CA$133.3m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

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 9.1 times the interest expense over the last year. On top of that, Hammond Manufacturing grew its EBIT by 44% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Hammond Manufacturing'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Hammond Manufacturing recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

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. In particular, conversion of EBIT to free cash flow gives us cold feet. When we consider all the factors mentioned above, we do feel a bit cautious about Hammond Manufacturing's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. For example - Hammond Manufacturing has 1 warning sign we think you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.