Here's Why Hindustan Foods (NSE:HNDFDS) Can Manage Its Debt Responsibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 can see that Hindustan Foods Limited (NSE:HNDFDS) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 Hindustan Foods

What Is Hindustan Foods's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Hindustan Foods had ₹1.57b of debt, an increase on ₹1.27b, over one year. On the flip side, it has ₹271.1m in cash leading to net debt of about ₹1.30b.

How Strong Is Hindustan Foods's Balance Sheet?

According to the last reported balance sheet, Hindustan Foods had liabilities of ₹2.12b due within 12 months, and liabilities of ₹1.65b due beyond 12 months. Offsetting these obligations, it had cash of ₹271.1m as well as receivables valued at ₹413.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹3.09b.

Since publicly traded Hindustan Foods shares are worth a total of ₹23.3b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

Hindustan Foods has net debt worth 1.9 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.7 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Pleasingly, Hindustan Foods is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 132% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Hindustan Foods's earnings that will influence how the balance sheet holds up in the future. 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 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, Hindustan Foods saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Based on what we've seen Hindustan Foods is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to grow its EBIT is pretty flash. Looking at all this data makes us feel a little cautious about Hindustan Foods's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 5 warning signs with Hindustan Foods (at least 3 which are a bit concerning) , 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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