HSIL (NSE:HSIL) Has A Somewhat Strained Balance Sheet

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, HSIL Limited (NSE:HSIL) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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, 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.

See our latest analysis for HSIL

What Is HSIL's Net Debt?

As you can see below, HSIL had ₹9.30b of debt at September 2020, down from ₹10.2b a year prior. However, because it has a cash reserve of ₹1.34b, its net debt is less, at about ₹7.96b.

A Look At HSIL's Liabilities

Zooming in on the latest balance sheet data, we can see that HSIL had liabilities of ₹6.07b due within 12 months and liabilities of ₹9.94b due beyond that. Offsetting this, it had ₹1.34b in cash and ₹2.92b in receivables that were due within 12 months. So its liabilities total ₹11.7b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of ₹11.7b, we think shareholders really should watch HSIL's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). 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).

HSIL's debt is 2.9 times its EBITDA, and its EBIT cover its interest expense 2.5 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Investors should also be troubled by the fact that HSIL saw its EBIT drop by 12% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since HSIL will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, HSIL recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

We'd go so far as to say HSIL's conversion of EBIT to free cash flow was disappointing. And furthermore, its level of total liabilities also fails to instill confidence. Taking into account all the aforementioned factors, it looks like HSIL has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that HSIL is showing 4 warning signs in our investment analysis , and 2 of those are a bit concerning...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. 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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