Harley-Davidson (NYSE:HOG) Seems To Use Debt Quite Sensibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Harley-Davidson, Inc. (NYSE:HOG) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Harley-Davidson

How Much Debt Does Harley-Davidson Carry?

The image below, which you can click on for greater detail, shows that at March 2023 Harley-Davidson had debt of US$7.19b, up from US$6.61b in one year. However, it does have US$876.2m in cash offsetting this, leading to net debt of about US$6.32b.

How Strong Is Harley-Davidson's Balance Sheet?

We can see from the most recent balance sheet that Harley-Davidson had liabilities of US$3.08b falling due within a year, and liabilities of US$5.85b due beyond that. Offsetting these obligations, it had cash of US$876.2m as well as receivables valued at US$333.5m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$7.72b.

When you consider that this deficiency exceeds the company's US$5.18b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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

As it happens Harley-Davidson has a fairly concerning net debt to EBITDA ratio of 5.3 but very strong interest coverage of 62.5. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Importantly, Harley-Davidson grew its EBIT by 32% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Harley-Davidson 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Harley-Davidson actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Both Harley-Davidson's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. But truth be told its level of total liabilities had us nibbling our nails. When we consider all the factors mentioned above, we do feel a bit cautious about Harley-Davidson's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. We've identified 3 warning signs with Harley-Davidson (at least 2 which are a bit unpleasant) , 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.