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

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Hammond Manufacturing Company Limited (TSE:HMM.A) does carry debt. But is this debt a concern to shareholders?

We've found 21 US stocks that are forecast to pay a dividend yield of over 6% next year. See the full list for free.

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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. When we think about a company's use of debt, we first look at cash and debt together.

What Is Hammond Manufacturing's Net Debt?

As you can see below, Hammond Manufacturing had CA$41.4m of debt at December 2024, down from CA$45.2m a year prior. On the flip side, it has CA$24.7m in cash leading to net debt of about CA$16.7m.

How Healthy Is Hammond Manufacturing's Balance Sheet?

According to the last reported balance sheet, Hammond Manufacturing had liabilities of CA$70.0m due within 12 months, and liabilities of CA$25.2m due beyond 12 months. Offsetting these obligations, it had cash of CA$24.7m as well as receivables valued at CA$32.6m due within 12 months. So it has liabilities totalling CA$38.0m more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Hammond Manufacturing has a market capitalization of CA$86.7m, 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.

Check out our latest analysis for Hammond Manufacturing

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 of just 0.49 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 9.6 times, which is more than adequate. While Hammond Manufacturing doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hammond Manufacturing will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot .

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. In the last three years, Hammond Manufacturing created free cash flow amounting to 13% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

While Hammond Manufacturing's conversion of EBIT to free cash flow does give us pause, its net debt to EBITDA and interest cover suggest it can stay on top of its debt load. Looking at all the angles mentioned above, it does seem to us that Hammond Manufacturing is a somewhat risky investment as a result of its debt. 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. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for Hammond Manufacturing that you should be aware of before investing here.

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.

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

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.