Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk. 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 H&R Block, Inc. (NYSE:HRB) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is H&R Block's Debt?
The chart below, which you can click on for greater detail, shows that H&R Block had US$1.49b in debt in July 2019; about the same as the year before. However, it also had US$607.7m in cash, and so its net debt is US$885.6m.
How Strong Is H&R Block's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that H&R Block had liabilities of US$733.0m due within 12 months and liabilities of US$2.09b due beyond that. On the other hand, it had cash of US$607.7m and US$76.1m worth of receivables due within a year. So it has liabilities totalling US$2.14b more than its cash and near-term receivables, combined.
This deficit isn't so bad because H&R Block is worth US$5.05b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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).
With net debt sitting at just 1.2 times EBITDA, H&R Block is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 9.0 times the interest expense over the last year. In fact H&R Block's saving grace is its low debt levels, because its EBIT has tanked 20% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine H&R Block'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, H&R Block recorded free cash flow worth a fulsome 82% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
Based on what we've seen H&R Block is not finding it easy EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its conversion of EBIT to free cash flow. Looking at all this data makes us feel a little cautious about H&R Block's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check H&R Block's dividend history, without delay!
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.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.