Is HFCL (NSE:HFCL) A Risky Investment?

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 can see that HFCL Limited (NSE:HFCL) does use debt in its business. But should shareholders be worried about its use of debt?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

View our latest analysis for HFCL

What Is HFCL's Debt?

The image below, which you can click on for greater detail, shows that at September 2022 HFCL had debt of ₹7.33b, up from ₹6.84b in one year. However, it also had ₹3.31b in cash, and so its net debt is ₹4.02b.

How Healthy Is HFCL's Balance Sheet?

According to the last reported balance sheet, HFCL had liabilities of ₹21.8b due within 12 months, and liabilities of ₹1.79b due beyond 12 months. On the other hand, it had cash of ₹3.31b and ₹19.1b worth of receivables due within a year. So it has liabilities totalling ₹1.22b more than its cash and near-term receivables, combined.

Having regard to HFCL's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the ₹109.1b company is short on cash, but still worth keeping an eye on the balance sheet.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

HFCL has a low net debt to EBITDA ratio of only 0.70. And its EBIT covers its interest expense a whopping 10.7 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The modesty of its debt load may become crucial for HFCL if management cannot prevent a repeat of the 21% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is HFCL'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 it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, HFCL actually recorded a cash outflow, overall. 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

While HFCL's conversion of EBIT to free cash flow makes us cautious about it, its track record of (not) growing its EBIT is no better. But at least its interest cover is a gleaming silver lining to those clouds. Taking the abovementioned factors together we do think HFCL's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. For example, we've discovered 1 warning sign for HFCL that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.