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. We can see that HomeServe plc (LON:HSV) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
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, 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is HomeServe's Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 HomeServe had UK£377.3m of debt, an increase on UK£295.6m, over one year. However, because it has a cash reserve of UK£72.6m, its net debt is less, at about UK£304.7m.
How Strong Is HomeServe's Balance Sheet?
The latest balance sheet data shows that HomeServe had liabilities of UK£434.2m due within a year, and liabilities of UK£386.8m falling due after that. Offsetting this, it had UK£72.6m in cash and UK£412.0m in receivables that were due within 12 months. So it has liabilities totalling UK£336.4m more than its cash and near-term receivables, combined.
Of course, HomeServe has a market capitalization of UK£3.87b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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.
HomeServe's net debt to EBITDA ratio of about 1.6 suggests only moderate use of debt. And its strong interest cover of 13.3 times, makes us even more comfortable. If HomeServe can keep growing EBIT at last year's rate of 11% over the last year, then it will find its debt load easier to manage. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if HomeServe can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, HomeServe recorded free cash flow of 27% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Happily, HomeServe's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. All these things considered, it appears that HomeServe 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. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that HomeServe insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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