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.’ 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. We can see that HNI Corporation (NYSE:HNI) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
What Is HNI’s Debt?
As you can see below, HNI had US$177.9m of debt, at October 2021, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$127.7m in cash leading to net debt of about US$50.2m.
How Healthy Is HNI’s Balance Sheet?
According to the last reported balance sheet, HNI had liabilities of US$494.1m due within 12 months, and liabilities of US$410.5m due beyond 12 months. On the other hand, it had cash of US$127.7m and US$235.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$541.2m.
This deficit isn’t so bad because HNI is worth US$1.83b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
HNI’s net debt is only 0.29 times its EBITDA. And its EBIT covers its interest expense a whopping 15.9 times over. So we’re pretty relaxed about its super-conservative use of debt. But the bad news is that HNI has seen its EBIT plunge 13% 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 HNI’s ability to maintain a healthy balance sheet going forward.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, HNI actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Happily, HNI’s impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its EBIT growth rate. Looking at all the aforementioned factors together, it strikes us that HNI can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one.