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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Hiap Hoe Limited (SGX:5JK) does carry debt. 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 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Hiap Hoe's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Hiap Hoe had S$728.0m of debt, an increase on S$672.7m, over one year. However, it also had S$292.5m in cash, and so its net debt is S$435.5m.
How Strong Is Hiap Hoe's Balance Sheet?
According to the last reported balance sheet, Hiap Hoe had liabilities of S$446.6m due within 12 months, and liabilities of S$415.0m due beyond 12 months. On the other hand, it had cash of S$292.5m and S$6.27m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by S$562.9m.
This deficit casts a shadow over the S$371.7m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Hiap Hoe would probably need a major re-capitalization if its creditors were to demand repayment.
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.
Hiap Hoe shareholders face the double whammy of a high net debt to EBITDA ratio (12.6), and fairly weak interest coverage, since EBIT is just 0.69 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Hiap Hoe's EBIT was down 90% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Hiap Hoe will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
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 three years, Hiap Hoe actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
On the face of it, Hiap Hoe's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Hiap Hoe's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Even though Hiap Hoe lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check outhow earnings have been trending over the last few years.
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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