Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ 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. As with many other companies Houston Wire & Cable Company (NASDAQ:HWCC) makes use of debt. But the more important question is: how much risk is that debt creating?
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, 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.
What Is Houston Wire & Cable’s Debt?
As you can see below, Houston Wire & Cable had US$73.4m of debt at June 2019, down from US$81.5m a year prior. Net debt is about the same, since the it doesn’t have much cash.
How Healthy Is Houston Wire & Cable’s Balance Sheet?
According to the last reported balance sheet, Houston Wire & Cable had liabilities of US$38.3m due within 12 months, and liabilities of US$82.4m due beyond 12 months. On the other hand, it had cash of US$256.0k and US$59.8m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$60.7m.
This deficit is considerable relative to its market capitalization of US$74.9m, so it does suggest shareholders should keep an eye on Houston Wire & Cable’s use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Houston Wire & Cable’s debt is 4.8 times its EBITDA, and its EBIT cover its interest expense 4.4 times over. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. The good news is that Houston Wire & Cable improved its EBIT by 4.0% over the last twelve years, thus gradually reducing its debt levels relative to its earnings. When analysing debt levels, the balance sheet is the obvious place to start. But you can’t view debt in total isolation; since Houston Wire & Cable 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last two years, Houston Wire & Cable recorded negative free cash flow, in total. 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.
On the face of it, Houston Wire & Cable’s net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn’t such a worry. Looking at the bigger picture, it seems clear to us that Houston Wire & Cable’s use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Given our hesitation about the stock, it would be good to know if Houston Wire & Cable insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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