Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that HGL Limited (ASX:HNG) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is HGL's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 HGL had AU$3.89m of debt, an increase on , over one year. However, it does have AU$5.46m in cash offsetting this, leading to net cash of AU$1.57m.
How Strong Is HGL's Balance Sheet?
According to the last reported balance sheet, HGL had liabilities of AU$11.4m due within 12 months, and liabilities of AU$5.52m due beyond 12 months. On the other hand, it had cash of AU$5.46m and AU$5.08m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$6.39m.
This deficit isn't so bad because HGL is worth AU$20.7m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, HGL also has more cash than debt, so we're pretty confident it can manage its debt safely.
Shareholders should be aware that HGL's EBIT was down 86% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since HGL 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. While HGL has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last three years, HGL created free cash flow amounting to 5.5% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
While HGL does have more liabilities than liquid assets, it also has net cash of AU$1.57m. Despite its cash we think that HGL seems to struggle to grow its EBIT, so we are wary of the stock. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check HGL's dividend history, without delay!
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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If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.