Howard Marks said it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and that every practical investor that I know is worried”. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. Above all, H&R Block, Inc. (NYSE:HRB) is in debt. But should shareholders worry about its use of debt?

When is debt dangerous?

Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.

See our latest analysis for H&R Block

What is H&R Block’s net debt?

The image below, which you can click on for more details, shows that in March 2022, H&R Block had $1.99 billion in debt, up from $1.49 billion in one year. However, he has $1.04 billion in cash to offset this, resulting in a net debt of approximately $944.2 million.

How healthy is H&R Block’s balance sheet?

Zooming in on the latest balance sheet data, we can see that H&R Block had liabilities of US$1.69 billion due within 12 months and liabilities of US$2.04 billion due beyond. In compensation for these obligations, it had cash of US$1.04 billion as well as receivables valued at US$602.0 million maturing within 12 months. Thus, its liabilities outweigh the sum of its cash and (current) receivables of US$2.09 billion.

H&R Block has a market capitalization of US$4.53 billion, so it could very likely raise funds to improve its balance sheet, should the need arise. However, it is always worth taking a close look at its ability to repay debt.

We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). Thus, we consider debt to earnings with and without amortization and depreciation expense.

H&R Block has net debt of just 1.2x EBITDA, indicating it is certainly not an imprudent borrower. And this view is supported by strong interest coverage, with EBIT amounting to 8.9 times interest expense over the past year. Although H&R Block doesn’t seem to have gained much on the EBIT line, at least earnings are holding steady for now. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future earnings, more than anything, that will determine H&R Block’s ability to maintain a healthy balance sheet in the future. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.

Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, H&R Block’s free cash flow has been 47% of its EBIT, less than expected. It’s not great when it comes to paying off debt.

Our point of view

H&R Block’s ability to cover its interest expense with its EBIT and net debt to EBITDA reassured us of its ability to manage its debt. On the other hand, its level of total liabilities makes us a little less comfortable about its indebtedness. When we consider all the factors mentioned above, we feel a bit cautious about H&R Block’s use of debt. While debt has its upside in higher potential returns, we think shareholders should certainly consider how debt levels might make the stock more risky. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist outside of the balance sheet. These risks can be difficult to spot. Every business has them, and we’ve spotted 3 warning signs for H&R Block (2 of which are concerning!) that you should know about.

In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeright now.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.