Hercules Site Services (LON:HERC) Seems To Use Debt Quite Sensibly

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Hercules Site Services Plc (LON:HERC) does use debt in its business. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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 Hercules Site Services

How Much Debt Does Hercules Site Services Carry?

You can click the graphic below for the historical numbers, but it shows that Hercules Site Services had UK£6.00m of debt in March 2024, down from UK£8.69m, one year before. However, it also had UK£1.70m in cash, and so its net debt is UK£4.30m.

How Healthy Is Hercules Site Services' Balance Sheet?

According to the last reported balance sheet, Hercules Site Services had liabilities of UK£20.0m due within 12 months, and liabilities of UK£11.9m due beyond 12 months. Offsetting these obligations, it had cash of UK£1.70m as well as receivables valued at UK£17.4m due within 12 months. So it has liabilities totalling UK£12.8m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Hercules Site Services is worth UK£25.7m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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.

Given net debt is only 1.4 times EBITDA, it is initially surprising to see that Hercules Site Services's EBIT has low interest coverage of 1.8 times. So one way or the other, it's clear the debt levels are not trivial. Notably, Hercules Site Services's EBIT launched higher than Elon Musk, gaining a whopping 253% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Hercules Site Services's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last two years, Hercules Site Services actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

The good news is that Hercules Site Services's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its interest cover. All these things considered, it appears that Hercules Site Services can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 4 warning signs for Hercules Site Services (1 is a bit unpleasant!) that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.

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