HomeChoice International (JSE:HIL) Seems To Use Debt Quite Sensibly

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, HomeChoice International plc (JSE:HIL) does carry debt. But is this debt a concern to shareholders?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for HomeChoice International

What Is HomeChoice International's Debt?

As you can see below, at the end of June 2020, HomeChoice International had R985.0m of debt, up from R885.0m a year ago. Click the image for more detail. However, it does have R386.0m in cash offsetting this, leading to net debt of about R599.0m.

A Look At HomeChoice International's Liabilities

Zooming in on the latest balance sheet data, we can see that HomeChoice International had liabilities of R356.0m due within 12 months and liabilities of R1.06b due beyond that. Offsetting this, it had R386.0m in cash and R1.57b in receivables that were due within 12 months. So it can boast R536.0m more liquid assets than total liabilities.

This excess liquidity suggests that HomeChoice International is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders.

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.

HomeChoice International has a low net debt to EBITDA ratio of only 1.2. And its EBIT covers its interest expense a whopping 14.4 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It is just as well that HomeChoice International's load is not too heavy, because its EBIT was down 34% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But it is HomeChoice International's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. In the last three years, HomeChoice International's free cash flow amounted to 28% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

HomeChoice International's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. Considering this range of data points, we think HomeChoice International is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with HomeChoice International , 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. 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.
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