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Warren Buffett famously said, '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. As with many other companies HRL Holdings Limited (ASX:HRL) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does HRL Holdings Carry?
As you can see below, HRL Holdings had AU$2.32m of debt at December 2020, down from AU$3.56m a year prior. But on the other hand it also has AU$3.75m in cash, leading to a AU$1.43m net cash position.
How Strong Is HRL Holdings' Balance Sheet?
The latest balance sheet data shows that HRL Holdings had liabilities of AU$7.92m due within a year, and liabilities of AU$2.57m falling due after that. Offsetting this, it had AU$3.75m in cash and AU$3.44m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$3.31m.
Since publicly traded HRL Holdings shares are worth a total of AU$61.7m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, HRL Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.
Better yet, HRL Holdings grew its EBIT by 262% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine HRL Holdings'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. HRL Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent two years, HRL Holdings recorded free cash flow worth 50% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
While it is always sensible to look at a company's total liabilities, it is very reassuring that HRL Holdings has AU$1.43m in net cash. And we liked the look of last year's 262% year-on-year EBIT growth. So is HRL Holdings's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that HRL Holdings is showing 1 warning sign in our investment analysis , you should know about...
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.
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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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