David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Michael Hill International Limited (ASX:MHJ) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Michael Hill International's Net Debt?
As you can see below, at the end of December 2019, Michael Hill International had AU$32.8m of debt, up from AU$28.7m a year ago. Click the image for more detail. But it also has AU$33.2m in cash to offset that, meaning it has AU$379.0k net cash.
How Strong Is Michael Hill International's Balance Sheet?
We can see from the most recent balance sheet that Michael Hill International had liabilities of AU$169.7m falling due within a year, and liabilities of AU$234.1m due beyond that. Offsetting these obligations, it had cash of AU$33.2m as well as receivables valued at AU$35.0m due within 12 months. So its liabilities total AU$335.7m more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's AU$224.9m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. Given that Michael Hill International has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.
But the bad news is that Michael Hill International has seen its EBIT plunge 15% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Michael Hill International'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Michael Hill International 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. During the last three years, Michael Hill International generated free cash flow amounting to a very robust 85% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Although Michael Hill International's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$379.0k. And it impressed us with free cash flow of AU$62m, being 85% of its EBIT. So although we see some areas for improvement, we're not too worried about Michael Hill International's balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - Michael Hill International has 2 warning signs we think you should be aware of.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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.
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