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. It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Harsco Corporation (NYSE:HSC) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Harsco Carry?
The image below, which you can click on for greater detail, shows that at June 2019 Harsco had debt of US$1.33b, up from US$666.4m in one year. However, it does have US$106.1m in cash offsetting this, leading to net debt of about US$1.23b.
How Strong Is Harsco's Balance Sheet?
According to the last reported balance sheet, Harsco had liabilities of US$532.6m due within 12 months, and liabilities of US$1.65b due beyond 12 months. Offsetting these obligations, it had cash of US$106.1m as well as receivables valued at US$394.6m due within 12 months. So its liabilities total US$1.68b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of US$1.72b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Harsco has a debt to EBITDA ratio of 3.9 and its EBIT covered its interest expense 5.0 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Also relevant is that Harsco has grown its EBIT by a very respectable 29% in the last year, thus enhancing its ability to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Harsco 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Harsco recorded free cash flow of 33% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Neither Harsco's ability to handle its total liabilities nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Harsco 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. Given our hesitation about the stock, it would be good to know if Harsco insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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