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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.’ 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 Hitech Corporation Limited (NSE:HITECHCORP) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. 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.
What Is Hitech’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Hitech had ₹1.72b of debt, an increase on ₹1.63b, over one year. And it doesn’t have much cash, so its net debt is about the same.
How Strong Is Hitech’s Balance Sheet?
According to the last reported balance sheet, Hitech had liabilities of ₹1.22b due within 12 months, and liabilities of ₹1.17b due beyond 12 months. Offsetting this, it had ₹12.2m in cash and ₹602.2m in receivables that were due within 12 months. So it has liabilities totalling ₹1.78b more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company’s market capitalization of ₹1.36b, we think shareholders really should watch Hitech’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. Either way, since Hitech does have more debt than cash, it’s worth keeping an eye on its balance sheet.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).
While we wouldn’t blink an eye at Hitech’s net debt to EBITDA ratio of 3.60, we think its super-low interest cover of 1.51 times is a bad sign. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. The good news is that Hitech grew its EBIT a smooth 51% over the last twelve months. Like a mother’s loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Hitech’s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Hitech saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
To be frank both Hitech’s interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it’s pretty decent at growing its EBIT; that’s encouraging. We’re quite clear that we consider Hitech to be really rather risky, as a result of its debt. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on the balance sheet . Over time, share prices tend to follow earnings per share, so if you’re interested in Hitech, you may well want to click here to check an interactive graph of its earnings per share history.
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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If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.