Over the past few weeks I have been watching the developments of the banking and tax service industry, which has provided an excellent opportunity to search for investment stocks in this sector. One company I think is very interesting to analyze is H&R Block Inc. (HRB). Its tax service segment assists income tax return preparations, in addition to providing digital tax solutions and other related services to the general public in the U.S., Canada and Australia.
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After HSBC Holdings Plc (ADR) (HSBC) discontinued its work with the company, in order to provide Refund Anticipation Loans, the firm created a separate entity to run banking products. This caused rating agencies to upgrade H&R's status, with expectations that the firm will sell its H&R Block Bank in the medium term future.
While there are many different factors to look at and consider when investing, in the article below I will look at the debt side of the company. I will analyze this company's total debt, total liabilities, debt ratios and what analysts and other top investors are expecting from it. From this analysis we should get an idea if the company is highly leveraged and how much to expect in return for investing in this company over the long term.
It is essential to remark that gaining knowledge about the firm's debt and liabilities is a key component in understanding the risk of investing in it. By studying the debt part of H&R Block, the investor can understand if it's able to keep its capital and use it for growth in the future.
Total Debt to Total Assets Ratio
This metric is used to measure a company's financial risk by determining how much of the company's assets have been financed by debt. It results from adding short-term and long-term debt and then dividing this figure by the company's total assets. If the outcome is higher than 1, it means that a company's total debt surpasses the value of its total assets. To the contrary, the company's assets are worth more than its total debt. The total debt to total assets ratio can come in extremely handy when investors want to determine a company's level of risk.
H&R Block's total debt to total assets ratio has increased very slightly over the past three years, from 0.19 to 0.20. This indicates that since 2010, the company has added more total debt value than total assets, which is not a good sign for bond investors. However, as this figure is currently well below 1 (0.20), H&R faces low financial risk.
Debt ratio = Total Liabilities / Total Assets
The debt ratio shows the proportion of a company's assets that is financed through debt. If the ratio is less than 0.5, most of the company's assets are financed through equity. If not, then the company's assets are financed through debt. Companies with high debt/asset ratios are said to be "highly leveraged," making it vulnerable if creditors start to demand repayment of debt.
When looking at H&R's debt ratio over the past three years, we can see that it has diminished from 0.72 to 0.71, which is encouraging. However, since the 2013 TTM numbers are above the 0.50 mark, it's clear that the company has been financing most of its assets through debt. Since the number has increased, so has the risk of investing in the company.
Debt-to-Equity Ratio = Total Liabilities / Shareholders' Equity
This metric compares a company's total liabilities with its total shareholders' equity. It's also a measure of how much suppliers, lenders, creditors and obligators have committed to the company, versus what the shareholders have committed. A high debt-to-equity ratio generally means that a company has been aggressive in financing its growth with debt, which can result in its reporting volatile earnings. It also points out that a company may not be able to generate enough cash to satisfy its debt obligations, therefore making it a riskier investment.
Compared with 2011, H&R's debt-to-equity ratio has decreased. The figure contracted from 2.65 to a current 2.58. I consider this a good sign, because the company currently has a less risky balance sheet than in the past. Nevertheless, the ratio of 2.58 - which surpasses 1 - implies that the company faces high risks, and so do their investors, since they have invested more than suppliers, lenders, creditors and obligators.
Capitalization Ratio = LT Debt / LT Debt + Shareholders' Equity (LT Debt = Long-Term Debt)
The capitalization ratio tells investors the extent to which the company is using its equity to support operations and growth, helping in the assessment of risk. Companies with a high capitalization ratio are considered to be risky: If they fail to repay their debt on time, jeopardy of insolvency increases drastically, making it difficult to get more loans in the future.
Over the past three years, H&R's capitalization ratio has remained the same (0.42), posing a moderate financial risk. This implies that the company has less equity compared with its long-term debt. As this is the case, the company has had less equity to support its operations and add growth through its equity. If the ratio increases, so will the risk for the company.
Cash Flow to Total Debt Ratio = Operating Cash Flow / Total Debt
This coverage ratio compares a company's operating cash flow with its total debt, indicating a firm's ability to cover total debt with its yearly cash flow from operations. The larger the ratio, the better a company can weather rough economic conditions.
As the ratio currently stands below 1, the company is unable to cover its total debt with its yearly cash flow from operations. The ideal is finding stocks that have ratios well above 1.
It's important to know that both Pioneer Investments (Trades, Portfolio) and Andreas Halvorsen (Trades, Portfolio) invested H&R's stock this past quarter, buying over 20,000 shares each, at an average price of $28.41.
Several analysts expect H&R Block to perform well over the upcoming years. Yahoo! Finance, for example, is expecting the bank to retrieve an EPS of $2.04 for 2014's fiscal year, while analysts at Bloomberg estimate that revenue will climb from 2013's $3.01 billion to an approximate $3.18 billion in 2014. On Sept. 1, 2014, BTIG gave H&R Block a rating of "Buy" with a target price of $35.63, implying significant upside potential from this point.
Although some debt aspects of H&R's financial balance sheet have been stronger in the past, analysts expect 2014 to be a profitable year for the firm, assigning it a "buy" rating. This leaves me feeling somewhat bullish in regards to an investment, and with the stock trading at a 3% price discount relative to the industry average of 21x, this may be the right time for investors to buy shares, before the price increases.
Disclosure: Victor Selva holds no position in any stocks mentioned.
This article first appeared on GuruFocus.