Herkules (WSE:HRS) has a somewhat strained balance sheet
Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. Mostly, Hercules S.A. (WSE:HRS) is in debt. But should shareholders worry about its use of debt?
What risk does debt carry?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. If things go really bad, lenders can take over the business. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
Check out our latest analysis for Herkules
What is Hercules’ debt?
You can click on the graph below for historical figures, but it shows that Herkules had 26.5 million zł in debt in September 2021, compared to 31.6 million zł a year before. On the other hand, it has 12.9 million zł of liquid assets, which results in a net debt of approximately 13.6 million zł.
A look at the responsibilities of Herkules
Zooming in on the latest balance sheet data, we can see that Herkules had liabilities of zł 112.7 million due within 12 months and liabilities of zł 80.2 million due beyond. In return, it had zł 12.9 million in cash and zł 77.9 million in receivables due within 12 months. It therefore has liabilities totaling zł 102.2 million more than its cash and short-term receivables, combined.
This deficit casts a shadow over the company of 52.0 million zł, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Herkules would likely need a major recapitalization if it were to pay its creditors today.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Looking at its net debt to EBITDA of 0.52 and its interest coverage of 4.0 times, it seems to us that Herkules is probably using debt quite sensibly. But the interest payments are certainly enough to make us think about the affordability of its debt. Shareholders should know that Herkules’ EBIT fell by 45% last year. If this earnings trend continues, paying off debt will be about as easy as herding cats on a roller coaster. When analyzing debt levels, the balance sheet is the obvious starting point. But you can’t look at debt in total isolation; since Herkules will need income to repay this debt. So, if you want to know more about its earnings, it may be worth checking out this graph of its long-term trend.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We therefore always check how much of this EBIT is converted into free cash flow. Over the past two years, Herkules has recorded free cash flow of 66% of its EBIT, which is about normal, given that free cash flow excludes interest and taxes. This cold hard cash allows him to reduce his debt whenever he wants.
Our point of view
At first glance, Herkules’ EBIT growth rate left us hesitant about the stock, and its level of total liabilities was no more appealing than the single empty restaurant on the busiest night of the year. But on the bright side, its net debt to EBITDA is a good sign and makes us more optimistic. We are quite clear that we consider Herkules to be really rather risky, given the health of its balance sheet. For this reason, we are quite cautious about the stock and believe shareholders should keep a close eye on its liquidity. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist outside of the balance sheet. We have identified 3 warning signs with Herkules (at least 1 which we don’t like too much), and understanding them should be part of your investment process.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.