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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Eifelhöhen-Klinik AG (FRA:EIF) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Eifelhöhen-Klinik

What Is Eifelhöhen-Klinik's Net Debt?

As you can see below, Eifelhöhen-Klinik had €22.1m of debt at December 2018, down from €25.3m a year prior. On the flip side, it has €10.2m in cash leading to net debt of about €11.9m.

How Healthy Is Eifelhöhen-Klinik's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Eifelhöhen-Klinik had liabilities of €9.03m due within 12 months and liabilities of €30.5m due beyond that. Offsetting these obligations, it had cash of €10.2m as well as receivables valued at €7.00m due within 12 months. So it has liabilities totalling €22.4m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the €11.5m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt After all, Eifelhöhen-Klinik would likely require a major re-capitalisation if it had to pay its creditors today.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).

Weak interest cover of 0.013 times and a disturbingly high net debt to EBITDA ratio of 5.5 hit our confidence in Eifelhöhen-Klinik like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, Eifelhöhen-Klinik's EBIT was down 95% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Eifelhöhen-Klinik's earnings that will influence how the balance sheet holds up in the future. 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Eifelhöhen-Klinik burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Eifelhöhen-Klinik's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. It's also worth noting that Eifelhöhen-Klinik is in the Healthcare industry, which is often considered to be quite defensive. Considering everything we've mentioned above, it's fair to say that Eifelhöhen-Klinik is carrying heavy debt load. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. While Eifelhöhen-Klinik didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.