David Iben put it well when he said, “Volatility is not a risk that interests us. Our aim is to avoid the permanent loss of capital. ‘ Whenever we think about how risky a business is, we always like to look at the use of debt as over-indebtedness can lead to ruin. As with many other companies Halma plc (LON: HLMA) takes advantage of debt. But the more important question is, what is the risk this debt poses?
Why does debt pose a risk?
Debt helps a company until the company struggles to pay it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While this isn’t too common, we often see indebted companies permanently diluting their shareholders by forcing lenders to raise capital at a distressed price. The advantage of debt, of course, is that it is often cheap capital, especially when it replaces the dilution of a business with the ability to reinvest too high a return. When examining debt, we first look at both cash and debt levels together.
How much debt does Halma owe?
The image below, which you can click for more details, shows that Halma was in debt at £ 376.1million in September 2020, up from £ 336.6million in one year. However, this is offset by £ 125.5 million (UK) in cash, resulting in a net debt of around £ 250.6 million.
A look at Halma’s liabilities
The latest balance sheet data shows that Halma had liabilities of £ 290.5 million in one year and £ 468.7 million thereafter. This compares with £ 125.5 million in cash and £ 251.8 million in receivables due within 12 months. So it has liabilities of £ 381.9 million more than its cash and short-term receivables combined.
Of course, Halma has a gigantic market capitalization of £ 8.51 billion, so these liabilities are likely to be manageable. However, we think it’s worth keeping an eye on balance sheet strength as it can change over time.
We measure a company’s debt burden in relation to its profitability by looking at net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating how easily earnings before interest and taxes (EBIT) cover its interest costs (Interest coverage). The advantage of this approach is that we take into account both the absolute level of debt (with net debt to EBITDA) and the actual interest expenses associated with this debt (with its interest coverage ratio).
Halma’s net debt is only 0.84 times EBITDA. And his EBIT covers the interest expense a whopping 19.0 times. So one could argue that it is no more threatened from its debts than an elephant is from a mouse. But the other side of the story is that Halma’s EBIT was down 2.0% last year. If profits continue to decline at this rate, the company may find it increasingly difficult to manage its debt burden. Undoubtedly, we learn most about balance sheet debt. But ultimately, the company’s future profitability will determine whether Halma can strengthen its balance sheet over time. So if you are focused on the future, this is what you can check out here for free Analyst earnings forecast report.
After all, while tax officials may worship book profits while lenders only accept cold cash. So we have to see clearly whether this EBIT leads to a corresponding free cash flow. For the past three years, Halma has posted free cash flow of a whopping 87% of its EBIT, which is stronger than we would normally expect. That positions it well to pay off debt if so desired.
The good news is that Halma’s proven ability to use his EBIT to recoup his interest expenses delights us like a fluffy pup delights a toddler. But to be honest, we think the EBIT growth rate undermines that impression a bit. When zooming out, Halma seems to be using his debt fairly wisely; and that gets the nod from us. Finally, reasonable leverage can increase return on equity. Before most other metrics, we think it’s important to track how fast, if at all, earnings per share are growing. If you have come to this realization too, you are in luck because today you can Check out this interactive graph of Halma’s earnings per share for free.
If you’re one of those investors who prefers to buy debt-free stocks, don’t hesitate to discover it our exclusive list of net cash growth stocks, today.
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