These 4 Measures Indicate That Health and Happiness (H&H) International Holdings (HKG:1112) Is Using Debt Extensively

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Health and Happiness (H&H) International Holdings Limited (HKG:1112) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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

How Much Debt Does Health and Happiness (H&H) International Holdings Carry?

The image below, which you can click on for greater detail, shows that at June 2023 Health and Happiness (H&H) International Holdings had debt of CN¥10.1b, up from CN¥9.36b in one year. However, because it has a cash reserve of CN¥2.22b, its net debt is less, at about CN¥7.87b.

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

According to the last reported balance sheet, Health and Happiness (H&H) International Holdings had liabilities of CN¥5.10b due within 12 months, and liabilities of CN¥9.61b due beyond 12 months. Offsetting these obligations, it had cash of CN¥2.22b as well as receivables valued at CN¥1.03b due within 12 months. So its liabilities total CN¥11.5b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥5.85b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Health and Happiness (H&H) International Holdings would probably need a major re-capitalization if its creditors were to demand repayment.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Health and Happiness (H&H) International Holdings's debt is 3.9 times its EBITDA, and its EBIT cover its interest expense 3.1 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. On the other hand, Health and Happiness (H&H) International Holdings grew its EBIT by 29% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Health and Happiness (H&H) International Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Health and Happiness (H&H) International Holdings produced sturdy free cash flow equating to 79% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Health and Happiness (H&H) International Holdings's struggle to handle its total liabilities had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. In particular, its conversion of EBIT to free cash flow was re-invigorating. 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. We've identified 2 warning signs with Health and Happiness (H&H) International Holdings (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

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.