Here's Why Huon Aquaculture Group (ASX:HUO) Is Weighed Down By Its Debt Load
Simply Wall St
Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Huon Aquaculture Group Limited (ASX:HUO) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company 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.
The image below, which you can click on for greater detail, shows that at June 2019 Huon Aquaculture Group had debt of AU$143.6m, up from AU$84.1m in one year. And it doesn't have much cash, so its net debt is about the same.
ASX:HUO Historical Debt, September 4th 2019
A Look At Huon Aquaculture Group's Liabilities
The latest balance sheet data shows that Huon Aquaculture Group had liabilities of AU$92.3m due within a year, and liabilities of AU$193.3m falling due after that. On the other hand, it had cash of AU$2.61m and AU$32.0m worth of receivables due within a year. So it has liabilities totalling AU$250.9m more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of AU$394.8m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
While Huon Aquaculture Group's debt to EBITDA ratio (3.3) suggests that it uses some debt, its interest cover is very weak, at 1.5, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Worse, Huon Aquaculture Group's EBIT was down 63% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Huon Aquaculture Group's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Huon Aquaculture Group burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
On the face of it, Huon Aquaculture Group's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its net debt to EBITDA also fails to instill confidence. Taking into account all the aforementioned factors, it looks like Huon Aquaculture Group has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Given our concerns about Huon Aquaculture Group's debt levels, it seems only prudent to check if insiders have been ditching the stock.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.
