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Hanesbrands (NYSE:HBI) Takes On Some Risk With Its Use Of Debt

Simply Wall St

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Hanesbrands Inc. (NYSE:HBI) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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, 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.

See our latest analysis for Hanesbrands

How Much Debt Does Hanesbrands Carry?

You can click the graphic below for the historical numbers, but it shows that Hanesbrands had US$4.10b of debt in March 2019, down from US$4.53b, one year before. However, it also had US$287.1m in cash, and so its net debt is US$3.81b.

NYSE:HBI Historical Debt, July 29th 2019

A Look At Hanesbrands's Liabilities

According to the last reported balance sheet, Hanesbrands had liabilities of US$2.18b due within 12 months, and liabilities of US$4.63b due beyond 12 months. On the other hand, it had cash of US$287.1m and US$932.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$5.59b.

This deficit is considerable relative to its market capitalization of US$5.84b, so it does suggest shareholders should keep an eye on Hanesbrands's use of debt. 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.

Hanesbrands has a debt to EBITDA ratio of 3.5 and its EBIT covered its interest expense 4.9 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. We saw Hanesbrands grow its EBIT by 5.5% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Hanesbrands's ability to maintain a healthy balance sheet going forward. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Hanesbrands produced sturdy free cash flow equating to 62% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

While Hanesbrands's net debt to EBITDA makes us cautious about it, its track record of staying on top of its total liabilities is no better. But its not so bad at converting EBIT to free cash flow. When we consider all the factors discussed, it seems to us that Hanesbrands is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.