Harper Hygienics (WSE:HRP) Use Of Debt Could Be Considered Risky

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Harper Hygienics S.A. (WSE:HRP) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Harper Hygienics

How Much Debt Does Harper Hygienics Carry?

As you can see below, Harper Hygienics had zł73.2m of debt at September 2021, down from zł82.1m a year prior. Net debt is about the same, since the it doesn't have much cash.

A Look At Harper Hygienics' Liabilities

We can see from the most recent balance sheet that Harper Hygienics had liabilities of zł145.8m falling due within a year, and liabilities of zł53.4m due beyond that. Offsetting these obligations, it had cash of zł593.0k as well as receivables valued at zł67.1m due within 12 months. So its liabilities total zł131.5m more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the zł44.1m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Harper Hygienics would likely require a major re-capitalisation if it had to pay its creditors today.

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).

Harper Hygienics has a debt to EBITDA ratio of 4.5 and its EBIT covered its interest expense 3.3 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Worse, Harper Hygienics's EBIT was down 52% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But it is Harper Hygienics'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last two years, Harper Hygienics burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Harper Hygienics's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And furthermore, its net debt to EBITDA also fails to instill confidence. Considering everything we've mentioned above, it's fair to say that Harper Hygienics is carrying heavy debt load. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. 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 5 warning signs with Harper Hygienics (at least 1 which shouldn't be ignored) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.