We Think Hammond Power Solutions (TSE:HPS.A) Can Manage Its Debt With Ease

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. As with many other companies Hammond Power Solutions Inc. (TSE:HPS.A) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

Our analysis indicates that HPS.A is potentially undervalued!

What Is Hammond Power Solutions's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of October 2022 Hammond Power Solutions had CA$26.6m of debt, an increase on CA$23.4m, over one year. However, its balance sheet shows it holds CA$48.5m in cash, so it actually has CA$21.8m net cash.

How Strong Is Hammond Power Solutions' Balance Sheet?

According to the last reported balance sheet, Hammond Power Solutions had liabilities of CA$145.5m due within 12 months, and liabilities of CA$6.64m due beyond 12 months. Offsetting this, it had CA$48.5m in cash and CA$105.2m in receivables that were due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.

This state of affairs indicates that Hammond Power Solutions' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the CA$233.7m company is struggling for cash, we still think it's worth monitoring its balance sheet. Succinctly put, Hammond Power Solutions boasts net cash, so it's fair to say it does not have a heavy debt load!

Better yet, Hammond Power Solutions grew its EBIT by 150% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. 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. While Hammond Power Solutions has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Hammond Power Solutions recorded free cash flow worth a fulsome 91% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Hammond Power Solutions has net cash of CA$21.8m, as well as more liquid assets than liabilities. The cherry on top was that in converted 91% of that EBIT to free cash flow, bringing in CA$43m. So is Hammond Power Solutions's debt a risk? It doesn't seem so to us. 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 instance, we've identified 1 warning sign for Hammond Power Solutions that you should be aware of.

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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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.