Does Hoe Leong (SGX:H20) Have A Healthy Balance Sheet?

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.' 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. Importantly, Hoe Leong Corporation Ltd. (SGX:H20) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Hoe Leong

What Is Hoe Leong's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2023 Hoe Leong had S$11.5m of debt, an increase on S$10.7m, over one year. On the flip side, it has S$4.54m in cash leading to net debt of about S$7.00m.

How Healthy Is Hoe Leong's Balance Sheet?

The latest balance sheet data shows that Hoe Leong had liabilities of S$15.4m due within a year, and liabilities of S$4.18m falling due after that. On the other hand, it had cash of S$4.54m and S$11.4m worth of receivables due within a year. So it has liabilities totalling S$3.64m more than its cash and near-term receivables, combined.

Hoe Leong has a market capitalization of S$15.1m, so it could very likely raise cash to ameliorate 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 use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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 Hoe Leong's debt to EBITDA ratio (2.8) suggests that it uses some debt, its interest cover is very weak, at 2.2, suggesting high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, the silver lining was that Hoe Leong achieved a positive EBIT of S$1.2m in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hoe Leong will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Hoe Leong 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 Hoe Leong'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 its level of total liabilities is not so bad. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Hoe Leong stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 4 warning signs with Hoe Leong (at least 1 which doesn't sit too well with us) , 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.