Is Hammond Power Solutions (TSE: HPS.A) a risky investment?
Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but the fact that you suffer a permanent loss of capital. “. So it can be obvious that you need to consider debt, when you think about how risky a given stock is because too much debt can sink a business. Like many other companies Hammond Power Solutions Inc. (TSE: HPS.A) uses debt. But should shareholders be concerned about its use of debt?
What risk does debt entail?
Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. Of course, many companies use debt to finance their growth without negative consequences. When we think of a business’s use of debt, we first look at cash flow and debt together.
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What is Hammond Power Solutions’ debt?
The image below, which you can click for more details, shows that Hammond Power Solutions had a debt of C $ 21.4 million at the end of March 2021, a reduction from C $ 34.2 million. Canadian dollars over one year. However, given that it has a cash reserve of C $ 9.61 million, its net debt is less, at approximately C $ 11.8 million.
How strong is Hammond Power Solutions’ balance sheet?
The latest balance sheet data shows Hammond Power Solutions had C $ 70.0 million in debt due within one year, and C $ 7.55 million in debt due thereafter. On the other hand, it had C $ 9.61 million in cash and C $ 64.5 million in receivables due within a year. Its liabilities therefore total C $ 3.43 million more than the combination of its cash and short-term receivables.
Of course, Hammond Power Solutions has a market cap of C $ 129.1 million, so this liability is likely manageable. But there are enough liabilities that we would certainly recommend that shareholders continue to monitor the balance sheet going forward.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
Hammond Power Solutions’ net debt is only 0.70 times its EBITDA. And its EBIT covers its interest costs 12.8 times more. We could therefore say that he is no more threatened by his debt than an elephant is by a mouse. Modest indebtedness may become critical to Hammond Power Solutions if management cannot prevent a repeat of the 36% reduction in EBIT over the past year. Falling profits (if the trend continues) could eventually make even small debt risky enough. The balance sheet is clearly the area you need to focus on when analyzing debt. But it is future profits, more than anything, that will determine Hammond Power Solutions’ ability to maintain a healthy balance sheet going forward. So, if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Hammond Power Solutions has recorded free cash flow of 57% of its EBIT, which is close to normal given that free cash flow excludes interest and taxes. This free cash flow puts the business in a good position to repay debt, if any.
Our point of view
Based on what we’ve seen, Hammond Power Solutions doesn’t find it easy, given its rate of EBIT growth, but the other factors we’ve taken into account give us cause for optimism. There is no doubt that his ability to cover his interest costs with his EBIT is pretty flash. Given this range of data points, we believe Hammond Power Solutions is well positioned to manage its debt levels. But beware: we believe debt levels are high enough to warrant continued monitoring. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. To do this, you need to know the 1 warning sign we spotted with Hammond Power Solutions.
If you are interested in investing in companies that can generate profits without the burden of debt, check out this page free list of growing companies that have net cash on the balance sheet.
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