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 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 Hewlett Packard Enterprise Company (NYSE:HPE) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Hewlett Packard Enterprise Carry?
You can click the graphic below for the historical numbers, but it shows that Hewlett Packard Enterprise had US$11.4b of debt in April 2024, down from US$13.5b, one year before. However, because it has a cash reserve of US$2.12b, its net debt is less, at about US$9.25b.
How Healthy Is Hewlett Packard Enterprise's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Hewlett Packard Enterprise had liabilities of US$23.8b due within 12 months and liabilities of US$14.2b due beyond that. Offsetting these obligations, it had cash of US$2.12b as well as receivables valued at US$3.84b due within 12 months. So its liabilities total US$32.0b more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's massive market capitalization of US$27.2b, 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 measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Hewlett Packard Enterprise has net debt worth 1.9 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.4 times the interest expense. 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. The bad news is that Hewlett Packard Enterprise saw its EBIT decline by 10% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Hewlett Packard Enterprise can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
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. Over the most recent three years, Hewlett Packard Enterprise recorded free cash flow worth 80% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Our View
On the face of it, Hewlett Packard Enterprise's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Hewlett Packard Enterprise stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 3 warning signs we've spotted with Hewlett Packard Enterprise .
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com