Stock Analysis

We Think Hydratec Industries (AMS:HYDRA) Is Taking Some Risk With Its Debt

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ENXTAM:HYDRA
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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.' 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. We can see that Hydratec Industries NV (AMS:HYDRA) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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 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. 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.

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How Much Debt Does Hydratec Industries Carry?

The chart below, which you can click on for greater detail, shows that Hydratec Industries had €41.7m in debt in June 2020; about the same as the year before. However, it also had €5.57m in cash, and so its net debt is €36.1m.

debt-equity-history-analysis
ENXTAM:HYDRA Debt to Equity History December 16th 2020

A Look At Hydratec Industries's Liabilities

The latest balance sheet data shows that Hydratec Industries had liabilities of €102.6m due within a year, and liabilities of €35.4m falling due after that. Offsetting this, it had €5.57m in cash and €54.8m in receivables that were due within 12 months. So it has liabilities totalling €77.7m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of €67.1m, we think shareholders really should watch Hydratec Industries's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Hydratec Industries's debt is 2.5 times its EBITDA, and its EBIT cover its interest expense 4.7 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Unfortunately, Hydratec Industries saw its EBIT slide 9.0% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Hydratec Industries'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Hydratec Industries's free cash flow amounted to 31% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

To be frank both Hydratec Industries's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its interest cover is not so bad. We're quite clear that we consider Hydratec Industries to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Consider risks, for instance. Every company has them, and we've spotted 2 warning signs for Hydratec Industries you should know about.

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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About ENXTAM:HYDRA

Hydratec Industries

Hydratec Industries NV, through its subsidiaries, engages in the manufacture and sale of industrial systems and plastic components for food, health, and mobility markets in the Netherlands, rest of Europe, Asia, North America, South America, Africa, and Oceania.

Excellent balance sheet with solid track record and pays a dividend.