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HRL Holdings (ASX:HRL) Seems To Use Debt Quite Sensibly

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, HRL Holdings Limited (ASX:HRL) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

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See our latest analysis for HRL Holdings

What Is HRL Holdings's Net Debt?

As you can see below, HRL Holdings had AU$2.83m of debt, at June 2020, which is about the same as the year before. You can click the chart for greater detail. However, its balance sheet shows it holds AU$2.85m in cash, so it actually has AU$21.5k net cash.

debt-equity-history-analysis
debt-equity-history-analysis

How Strong Is HRL Holdings's Balance Sheet?

The latest balance sheet data shows that HRL Holdings had liabilities of AU$8.01m due within a year, and liabilities of AU$2.88m falling due after that. On the other hand, it had cash of AU$2.85m and AU$3.81m worth of receivables due within a year. So it has liabilities totalling AU$4.2m more than its cash and near-term receivables, combined.

Of course, HRL Holdings has a market capitalization of AU$55.5m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. 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.

Notably, HRL Holdings made a loss at the EBIT level, last year, but improved that to positive EBIT of AU$1.2m in the last twelve months. 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, a company can only pay off debt with cold hard cash, not accounting profits. 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. Happily for any shareholders, HRL Holdings actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

We could understand if investors are concerned about HRL Holdings's liabilities, but we can be reassured by the fact it has has net cash of AU$21.5k. The cherry on top was that in converted 366% of that EBIT to free cash flow, bringing in AU$4.3m. So we don't have any problem with HRL Holdings's use of debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with HRL Holdings , and understanding them should be part of your investment process.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com.