Is Hafnia (OB:HAFNI) 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.' 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. As with many other companies Hafnia Limited (OB:HAFNI) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Hafnia

What Is Hafnia's Debt?

The image below, which you can click on for greater detail, shows that Hafnia had debt of US$848.1m at the end of September 2022, a reduction from US$1.25b over a year. However, it also had US$151.5m in cash, and so its net debt is US$696.6m.

How Strong Is Hafnia's Balance Sheet?

We can see from the most recent balance sheet that Hafnia had liabilities of US$479.2m falling due within a year, and liabilities of US$1.58b due beyond that. On the other hand, it had cash of US$151.5m and US$633.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.27b.

This deficit isn't so bad because Hafnia is worth US$2.59b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With net debt sitting at just 1.1 times EBITDA, Hafnia is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 7.6 times the interest expense over the last year. It was also good to see that despite losing money on the EBIT line last year, Hafnia turned things around in the last 12 months, delivering and EBIT of US$523m. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hafnia can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Considering the last year, Hafnia actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Hafnia's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its net debt to EBITDA is relatively strong. Taking the abovementioned factors together we do think Hafnia's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. We've identified 4 warning signs with Hafnia (at least 2 which are a bit concerning) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.