Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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 note that Hewlett Packard Enterprise Company (NYSE:HPE) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Hewlett Packard Enterprise Carry?
As you can see below, Hewlett Packard Enterprise had US$13.4b of debt at October 2021, down from US$15.9b a year prior. However, it does have US$3.11b in cash offsetting this, leading to net debt of about US$10.3b.
A Look At Hewlett Packard Enterprise’s Liabilities
We can see from the most recent balance sheet that Hewlett Packard Enterprise had liabilities of US$20.7b falling due within a year, and liabilities of US$17.0b due beyond that. Offsetting this, it had US$3.11b in cash and US$4.93b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$29.6b.
Given this deficit is actually higher than the company’s massive market capitalization of US$21.7b, we think shareholders really should watch Hewlett Packard Enterprise’s debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). 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).
With a debt to EBITDA ratio of 2.1, Hewlett Packard Enterprise uses debt artfully but responsibly. And the alluring interest cover (EBIT of 8.3 times interest expense) certainly does not do anything to dispel this impression. Importantly, Hewlett Packard Enterprise grew its EBIT by 38% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Hewlett Packard Enterprise’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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Hewlett Packard Enterprise produced sturdy free cash flow equating to 64% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
When it comes to the balance sheet, the standout positive for Hewlett Packard Enterprise was the fact that it seems able to grow its EBIT confidently. But the other factors we noted above weren’t so encouraging. In particular, level of total liabilities gives us cold feet. When we consider all the factors mentioned above, we do feel a bit cautious about Hewlett Packard Enterprise’s use of debt. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. For instance, we’ve identified 4 warning signs for Hewlett Packard Enterprise (1 is a bit concerning) you should be aware of.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.