Stock Analysis

Is Home Control International (HKG:1747) Using Too Much Debt?

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SEHK:1747
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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 Home Control International Limited (HKG:1747) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

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What Is Home Control International's Debt?

You can click the graphic below for the historical numbers, but it shows that Home Control International had US$27.7m of debt in December 2020, down from US$39.4m, one year before. However, it does have US$22.3m in cash offsetting this, leading to net debt of about US$5.33m.

debt-equity-history-analysis
SEHK:1747 Debt to Equity History May 7th 2021

How Healthy Is Home Control International's Balance Sheet?

We can see from the most recent balance sheet that Home Control International had liabilities of US$43.6m falling due within a year, and liabilities of US$17.3m due beyond that. Offsetting these obligations, it had cash of US$22.3m as well as receivables valued at US$23.8m due within 12 months. So its liabilities total US$14.7m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Home Control International is worth US$58.8m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Looking at its net debt to EBITDA of 0.57 and interest cover of 3.0 times, it seems to us that Home Control International is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Importantly, Home Control International's EBIT fell a jaw-dropping 23% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Home Control International'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. Over the last three years, Home Control International 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

Based on what we've seen Home Control International 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 convert EBIT to free cash flow is pretty flash. Looking at all this data makes us feel a little cautious about Home Control International's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 4 warning signs for Home Control International (1 is significant!) that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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