Does H2O Innovation (CVE:HEO) Have A Healthy Balance Sheet?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We note that H2O Innovation Inc. (CVE:HEO) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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.

See our latest analysis for H2O Innovation

What Is H2O Innovation's Net Debt?

You can click the graphic below for the historical numbers, but it shows that H2O Innovation had CA$16.6m of debt in March 2021, down from CA$24.8m, one year before. However, it also had CA$13.3m in cash, and so its net debt is CA$3.29m.

A Look At H2O Innovation's Liabilities

Zooming in on the latest balance sheet data, we can see that H2O Innovation had liabilities of CA$32.3m due within 12 months and liabilities of CA$27.8m due beyond that. Offsetting this, it had CA$13.3m in cash and CA$27.3m in receivables that were due within 12 months. So its liabilities total CA$19.4m more than the combination of its cash and short-term receivables.

Since publicly traded H2O Innovation shares are worth a total of CA$203.3m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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.

While H2O Innovation's low debt to EBITDA ratio of 0.23 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.5 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Notably, H2O Innovation's EBIT launched higher than Elon Musk, gaining a whopping 237% on last year. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine H2O Innovation'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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, H2O Innovation actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

The good news is that H2O Innovation's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But truth be told we feel its interest cover does undermine this impression a bit. Looking at the bigger picture, we think H2O Innovation's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. Be aware that H2O Innovation is showing 2 warning signs in our investment analysis , you should know about...

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.

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This article by Simply Wall St is general in nature. 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.
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