Stock Analysis

Is Hammond Power Solutions (TSE:HPS.A) A Risky Investment?

TSX:HPS.A
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The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies Hammond Power Solutions Inc. (TSE:HPS.A) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Hammond Power Solutions

What Is Hammond Power Solutions's Debt?

The image below, which you can click on for greater detail, shows that Hammond Power Solutions had debt of CA$21.4m at the end of March 2021, a reduction from CA$34.2m over a year. However, because it has a cash reserve of CA$9.61m, its net debt is less, at about CA$11.8m.

debt-equity-history-analysis
TSX:HPS.A Debt to Equity History July 1st 2021

How Strong Is Hammond Power Solutions' Balance Sheet?

The latest balance sheet data shows that Hammond Power Solutions had liabilities of CA$70.0m due within a year, and liabilities of CA$7.55m falling due after that. On the other hand, it had cash of CA$9.61m and CA$64.5m worth of receivables due within a year. So its liabilities total CA$3.43m more than the combination of its cash and short-term receivables.

Of course, Hammond Power Solutions has a market capitalization of CA$129.1m, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). 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).

Hammond Power Solutions's net debt is only 0.70 times its EBITDA. And its EBIT covers its interest expense a whopping 12.8 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The modesty of its debt load may become crucial for Hammond Power Solutions if management cannot prevent a repeat of the 36% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Hammond Power Solutions's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Hammond Power Solutions recorded free cash flow worth 57% 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

Based on what we've seen Hammond Power Solutions is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. Considering this range of data points, we think Hammond Power Solutions is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. To that end, you should be aware of the 1 warning sign we've spotted with Hammond Power Solutions .

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.

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