Hovnanian Enterprises (NYSE:HOV) Takes On Some Risk With Its Use Of Debt

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 can see that Hovnanian Enterprises, Inc. (NYSE:HOV) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Hovnanian Enterprises

What Is Hovnanian Enterprises's Debt?

The image below, which you can click on for greater detail, shows that Hovnanian Enterprises had debt of US$1.34b at the end of April 2023, a reduction from US$1.42b over a year. However, it does have US$333.3m in cash offsetting this, leading to net debt of about US$1.01b.

How Strong Is Hovnanian Enterprises' Balance Sheet?

According to the last reported balance sheet, Hovnanian Enterprises had liabilities of US$460.5m due within 12 months, and liabilities of US$1.59b due beyond 12 months. Offsetting these obligations, it had cash of US$333.3m as well as receivables valued at US$37.2m due within 12 months. So it has liabilities totalling US$1.68b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the US$597.2m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Hovnanian Enterprises 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).

Hovnanian Enterprises's debt is 3.2 times its EBITDA, and its EBIT cover its interest expense 5.9 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Unfortunately, Hovnanian Enterprises saw its EBIT slide 2.5% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Hovnanian Enterprises 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Hovnanian Enterprises produced sturdy free cash flow equating to 68% 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.

Our View

Mulling over Hovnanian Enterprises's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the bigger picture, it seems clear to us that Hovnanian Enterprises'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. 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 2 warning signs with Hovnanian Enterprises (at least 1 which is potentially serious) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.