We Think Hammond Manufacturing (TSE:HMM.A) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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.

View our latest analysis for Hammond Manufacturing

What Is Hammond Manufacturing's Net Debt?

The image below, which you can click on for greater detail, shows that at July 2022 Hammond Manufacturing had debt of CA$30.4m, up from CA$17.7m in one year. However, because it has a cash reserve of CA$2.66m, its net debt is less, at about CA$27.7m.

How Healthy Is Hammond Manufacturing's Balance Sheet?

According to the last reported balance sheet, Hammond Manufacturing had liabilities of CA$52.4m due within 12 months, and liabilities of CA$24.2m due beyond 12 months. Offsetting this, it had CA$2.66m in cash and CA$30.8m in receivables that were due within 12 months. So its liabilities total CA$43.1m more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CA$45.9m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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

Hammond Manufacturing's net debt of 1.5 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 8.9 times its interest expenses harmonizes with that theme. Also good is that Hammond Manufacturing grew its EBIT at 11% over the last year, further increasing its ability to manage 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 it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Hammond Manufacturing's free cash flow amounted to 32% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

While Hammond Manufacturing's level of total liabilities does give us pause, its interest cover and EBIT growth rate suggest it can stay on top of its debt load. We think that Hammond Manufacturing's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For example, we've discovered 2 warning signs for Hammond Manufacturing that you should be aware of before investing here.

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.