Warren Buffett famously said, '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. We can see that Health and Happiness (H&H) International Holdings Limited (HKG:1112) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Health and Happiness (H&H) International Holdings Carry?
As you can see below, Health and Happiness (H&H) International Holdings had CN¥6.06b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it also had CN¥2.06b in cash, and so its net debt is CN¥4.00b.
How Healthy Is Health and Happiness (H&H) International Holdings's Balance Sheet?
The latest balance sheet data shows that Health and Happiness (H&H) International Holdings had liabilities of CN¥3.35b due within a year, and liabilities of CN¥7.01b falling due after that. Offsetting these obligations, it had cash of CN¥2.06b as well as receivables valued at CN¥1.03b due within 12 months. So its liabilities total CN¥7.27b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Health and Happiness (H&H) International Holdings has a market capitalization of CN¥17.4b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Health and Happiness (H&H) International Holdings's net debt is sitting at a very reasonable 1.7 times its EBITDA, while its EBIT covered its interest expense just 6.0 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. We saw Health and Happiness (H&H) International Holdings grow its EBIT by 9.7% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Health and Happiness (H&H) International Holdings's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
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. Over the most recent three years, Health and Happiness (H&H) International Holdings recorded free cash flow worth 70% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
The good news is that Health and Happiness (H&H) International Holdings's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And its EBIT growth rate is good too. All these things considered, it appears that Health and Happiness (H&H) International Holdings can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. Over time, share prices tend to follow earnings per share, so if you're interested in Health and Happiness (H&H) International Holdings, you may well want to click here to check an interactive graph of its earnings per share history.
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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