We Think Health and Happiness (H&H) International Holdings (HKG:1112) Is Taking Some Risk With Its Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We note that Health and Happiness (H&H) International Holdings Limited (HKG:1112) does have debt on its balance sheet. 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 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. 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 Health and Happiness (H&H) International Holdings

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

You can click the graphic below for the historical numbers, but it shows that Health and Happiness (H&H) International Holdings had CN¥5.97b of debt in June 2021, down from CN¥6.56b, one year before. However, it also had CN¥1.97b in cash, and so its net debt is CN¥4.00b.

How Healthy 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¥2.95b due within 12 months, and liabilities of CN¥7.45b due beyond 12 months. On the other hand, it had cash of CN¥1.97b and CN¥677.1m worth of receivables due within a year. So its liabilities total CN¥7.75b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥12.6b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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 net debt is sitting at a very reasonable 2.4 times its EBITDA, while its EBIT covered its interest expense just 5.9 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Unfortunately, Health and Happiness (H&H) International Holdings's EBIT flopped 20% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. 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 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 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 83% 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 EBIT growth rate and level of total liabilities 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. We think that Health and Happiness (H&H) International Holdings's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 - Health and Happiness (H&H) International Holdings has 3 warning signs we think you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.
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