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.' 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 Hovnanian Enterprises, Inc. (NYSE:HOV) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Hovnanian Enterprises Carry?

The image below, which you can click on for greater detail, shows that Hovnanian Enterprises had debt of US$986.9m at the end of October 2024, a reduction from US$1.25b over a year. However, it does have US$210.0m in cash offsetting this, leading to net debt of about US$776.9m.

How Healthy Is Hovnanian Enterprises' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hovnanian Enterprises had liabilities of US$453.3m due within 12 months and liabilities of US$1.35b due beyond that. On the other hand, it had cash of US$210.0m and US$29.4m worth of receivables due within a year. So its liabilities total US$1.57b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the US$1.03b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Hovnanian Enterprises would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a debt to EBITDA ratio of 2.5, Hovnanian Enterprises uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 9.9 times its interest expenses harmonizes with that theme. If Hovnanian Enterprises can keep growing EBIT at last year's rate of 11% over the last year, then it will find its debt load easier to manage. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hovnanian Enterprises 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Hovnanian Enterprises produced sturdy free cash flow equating to 56% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Hovnanian Enterprises's struggle to handle its total liabilities had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. In particular, its interest cover was re-invigorating. Taking the abovementioned factors together we do think Hovnanian Enterprises's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Hovnanian Enterprises (1 is a bit concerning) you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.