Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Hardwoods Distribution Inc. (TSE:HDI) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Hardwoods Distribution Carry?
As you can see below, Hardwoods Distribution had CA$95.7m of debt at June 2019, down from CA$129.8m a year prior. However, because it has a cash reserve of CA$3.39m, its net debt is less, at about CA$92.3m.
How Healthy Is Hardwoods Distribution's Balance Sheet?
According to the last reported balance sheet, Hardwoods Distribution had liabilities of CA$167.1m due within 12 months, and liabilities of CA$80.7m due beyond 12 months. On the other hand, it had cash of CA$3.39m and CA$125.1m worth of receivables due within a year. So it has liabilities totalling CA$119.3m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Hardwoods Distribution has a market capitalization of CA$255.7m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). 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 a debt to EBITDA ratio of 2.3, Hardwoods Distribution uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 9.9 times its interest expenses harmonizes with that theme. Unfortunately, Hardwoods Distribution's EBIT flopped 13% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Hardwoods Distribution's ability to maintain a healthy balance sheet going forward. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Hardwoods Distribution's free cash flow amounted to 43% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Neither Hardwoods Distribution's ability to grow its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Taking the abovementioned factors together we do think Hardwoods Distribution's debt poses some risks to the business. 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 Hardwoods Distribution insiders have sold any shares recently. You click here to find out if insiders have sold 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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