The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 note that Abano Healthcare Group Limited (NZSE:ABA) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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 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. 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.
What Is Abano Healthcare Group's Debt?
As you can see below, at the end of May 2019, Abano Healthcare Group had NZ$146.1m of debt, up from NZ$100.8m a year ago. Click the image for more detail. However, it does have NZ$3.13m in cash offsetting this, leading to net debt of about NZ$143.0m.
How Strong Is Abano Healthcare Group's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Abano Healthcare Group had liabilities of NZ$33.3m due within 12 months and liabilities of NZ$156.8m due beyond that. Offsetting this, it had NZ$3.13m in cash and NZ$12.3m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NZ$174.6m.
This deficit casts a shadow over the NZ$103.4m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt After all, Abano Healthcare Group would likely require a major re-capitalisation if it had to pay its creditors today.
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.
Abano Healthcare Group has a debt to EBITDA ratio of 4.5 and its EBIT covered its interest expense 3.7 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. More concerning, Abano Healthcare Group saw its EBIT drop by 7.3% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Abano Healthcare Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Abano Healthcare Group recorded free cash flow of 39% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Mulling over Abano Healthcare Group's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least its conversion of EBIT to free cash flow is not so bad. We should also note that Healthcare industry companies like Abano Healthcare Group commonly do use debt without problems. We're quite clear that we consider Abano Healthcare Group to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Given Abano Healthcare Group has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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