David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Hills Limited (ASX:HIL) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Hills

What Is Hills's Debt?

The image below, which you can click on for greater detail, shows that Hills had debt of AU$3.22m at the end of June 2022, a reduction from AU$20.0m over a year. But on the other hand it also has AU$6.46m in cash, leading to a AU$3.24m net cash position.

A Look At Hills' Liabilities

Zooming in on the latest balance sheet data, we can see that Hills had liabilities of AU$21.6m due within 12 months and liabilities of AU$4.97m due beyond that. Offsetting this, it had AU$6.46m in cash and AU$13.5m in receivables that were due within 12 months. So it has liabilities totalling AU$6.60m more than its cash and near-term receivables, combined.

Hills has a market capitalization of AU$15.3m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Despite its noteworthy liabilities, Hills boasts net cash, so it's fair to say it does not have a heavy debt load! There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Hills will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Over 12 months, Hills made a loss at the EBIT level, and saw its revenue drop to AU$47m, which is a fall of 74%. That makes us nervous, to say the least.

So How Risky Is Hills?

We have no doubt that loss making companies are, in general, riskier than profitable ones. And in the last year Hills had an earnings before interest and tax (EBIT) loss, truth be told. And over the same period it saw negative free cash outflow of AU$365k and booked a AU$8.3m accounting loss. While this does make the company a bit risky, it's important to remember it has net cash of AU$3.24m. That kitty means the company can keep spending for growth for at least two years, at current rates. Summing up, we're a little skeptical of this one, as it seems fairly risky in the absence of free cashflow. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Hills has 2 warning signs (and 1 which can't be ignored) we think you should know about.