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 can see that Hawaiian Electric Industries, Inc. (NYSE:HE) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Hawaiian Electric Industries's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Hawaiian Electric Industries had US$2.21b of debt, an increase on US$2.11b, over one year. On the flip side, it has US$199.0m in cash leading to net debt of about US$2.01b.
How Strong Is Hawaiian Electric Industries's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Hawaiian Electric Industries had liabilities of US$542.3m due within 12 months and liabilities of US$10.8b due beyond that. Offsetting these obligations, it had cash of US$199.0m as well as receivables valued at US$5.26b due within 12 months. So its liabilities total US$5.84b more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's US$4.78b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Hawaiian Electric Industries's debt is 3.4 times its EBITDA, and its EBIT cover its interest expense 3.5 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Even more troubling is the fact that Hawaiian Electric Industries actually let its EBIT decrease by 3.7% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its 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 Hawaiian Electric Industries 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, Hawaiian Electric Industries actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
On the face of it, Hawaiian Electric Industries's level of total liabilities left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. We should also note that Electric Utilities industry companies like Hawaiian Electric Industries commonly do use debt without problems. We're quite clear that we consider Hawaiian Electric Industries to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. Given our concerns about Hawaiian Electric Industries's debt levels, it seems only prudent to check if insiders have been ditching the stock.
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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