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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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, HNI Corporation (NYSE:HNI) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.
What Is HNI’s Debt?
You can click the graphic below for the historical numbers, but it shows that HNI had US$296.4m of debt in March 2019, down from US$329.0m, one year before However, it does have US$49.6m in cash offsetting this, leading to net debt of about US$246.8m.
How Strong Is HNI’s Balance Sheet?
We can see from the most recent balance sheet that HNI had liabilities of US$372.9m falling due within a year, and liabilities of US$505.3m due beyond that. Offsetting this, it had US$49.6m in cash and US$225.2m in receivables that were due within 12 months. So its liabilities total US$603.4m more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because HNI is worth US$1.51b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. Since HNI does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
HNI has a low net debt to EBITDA ratio of only 1.23. And its EBIT easily covers its interest expense, being 15.4 times the size. So we’re pretty relaxed about its super-conservative use of debt. And we also note warmly that HNI grew its EBIT by 12% last year, making its debt load easier to handle. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine HNI’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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 three years, HNI produced sturdy free cash flow equating to 52% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, HNI’s impressive interest cover implies it has the upper hand on its debt. And we also thought its EBIT growth rate was a positive. All these things considered, it appears that HNI can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. Given HNI has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.