Is Health and Happiness (H&H) International Holdings (HKG:1112) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. Importantly, Health and Happiness (H&H) International Holdings Limited (HKG:1112) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Health and Happiness (H&H) International Holdings

What Is Health and Happiness (H&H) International Holdings's Debt?

The chart below, which you can click on for greater detail, shows that Health and Happiness (H&H) International Holdings had CN¥9.57b in debt in December 2022; about the same as the year before. However, because it has a cash reserve of CN¥2.31b, its net debt is less, at about CN¥7.26b.

How Healthy Is Health and Happiness (H&H) International Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Health and Happiness (H&H) International Holdings had liabilities of CN¥5.13b due within 12 months and liabilities of CN¥9.69b due beyond that. Offsetting these obligations, it had cash of CN¥2.31b as well as receivables valued at CN¥825.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥11.7b.

Given this deficit is actually higher than the company's market capitalization of CN¥7.97b, we think shareholders really should watch Health and Happiness (H&H) International Holdings's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Health and Happiness (H&H) International Holdings's debt is 4.1 times its EBITDA, and its EBIT cover its interest expense 3.2 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. However, one redeeming factor is that Health and Happiness (H&H) International Holdings grew its EBIT at 15% over the last 12 months, boosting its ability to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Health and Happiness (H&H) International Holdings'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Health and Happiness (H&H) International Holdings recorded free cash flow worth a fulsome 100% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Health and Happiness (H&H) International Holdings's level of total liabilities and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. When we consider all the factors discussed, it seems to us that Health and Happiness (H&H) International Holdings is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. Be aware that Health and Happiness (H&H) International Holdings is showing 2 warning signs in our investment analysis , and 1 of those is concerning...

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.