The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Hamilton Beach Brands Holding Company (NYSE:HBB) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Hamilton Beach Brands Holding Carry?
The image below, which you can click on for greater detail, shows that Hamilton Beach Brands Holding had debt of US$91.0m at the end of June 2019, a reduction from US$105.5m over a year. Net debt is about the same, since the it doesn't have much cash.
How Healthy Is Hamilton Beach Brands Holding's Balance Sheet?
The latest balance sheet data shows that Hamilton Beach Brands Holding had liabilities of US$199.2m due within a year, and liabilities of US$47.5m falling due after that. Offsetting this, it had US$1.20m in cash and US$89.6m in receivables that were due within 12 months. So its liabilities total US$155.9m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of US$194.2m. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
Hamilton Beach Brands Holding's net debt of 2.4 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 9.4 times its interest expenses harmonizes with that theme. Importantly, Hamilton Beach Brands Holding's EBIT fell a jaw-dropping 25% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Hamilton Beach Brands Holding can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
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. Looking at the most recent three years, Hamilton Beach Brands Holding recorded free cash flow of 22% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
We'd go so far as to say Hamilton Beach Brands Holding's EBIT growth rate was disappointing. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Hamilton Beach Brands Holding's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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