These 4 Measures Indicate That Hill & Smith Holdings (LON:HILS) Is Using Debt Reasonably Well

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that Hill & Smith Holdings PLC (LON:HILS) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 Hill & Smith Holdings

What Is Hill & Smith Holdings's Debt?

The image below, which you can click on for greater detail, shows that at June 2022 Hill & Smith Holdings had debt of UK£151.0m, up from UK£137.9m in one year. However, because it has a cash reserve of UK£18.4m, its net debt is less, at about UK£132.6m.

How Healthy Is Hill & Smith Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hill & Smith Holdings had liabilities of UK£185.1m due within 12 months and liabilities of UK£192.7m due beyond that. Offsetting this, it had UK£18.4m in cash and UK£152.7m in receivables that were due within 12 months. So it has liabilities totalling UK£206.7m more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Hill & Smith Holdings has a market capitalization of UK£902.6m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Hill & Smith Holdings has a low net debt to EBITDA ratio of only 1.1. And its EBIT covers its interest expense a whopping 17.4 times over. So we're pretty relaxed about its super-conservative use of debt. On top of that, Hill & Smith Holdings grew its EBIT by 56% over the last twelve months, and that growth will make it easier to handle its debt. 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 Hill & Smith Holdings'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.

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. During the last three years, Hill & Smith Holdings produced sturdy free cash flow equating to 66% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that Hill & Smith Holdings's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its EBIT growth rate also supports that impression! Zooming out, Hill & Smith Holdings seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Hill & Smith Holdings that you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.