Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 MicroPort Scientific Corporation (HKG:853) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is MicroPort Scientific's Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2018 MicroPort Scientific had US$329.1m of debt, an increase on US$251.5m, over one year. However, it also had US$142.3m in cash, and so its net debt is US$186.9m.
How Healthy Is MicroPort Scientific's Balance Sheet?
The latest balance sheet data shows that MicroPort Scientific had liabilities of US$440.4m due within a year, and liabilities of US$305.1m falling due after that. Offsetting this, it had US$142.3m in cash and US$221.0m in receivables that were due within 12 months. So its liabilities total US$382.2m more than the combination of its cash and short-term receivables.
This deficit isn't so bad because MicroPort Scientific is worth US$1.26b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). 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).
MicroPort Scientific has net debt worth 2.1 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 2.5 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. The bad news is that MicroPort Scientific saw its EBIT decline by 11% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if MicroPort Scientific 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, MicroPort Scientific recorded free cash flow of 21% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
To be frank both MicroPort Scientific's EBIT growth rate and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. Having said that, its ability to handle its total liabilities isn't such a worry. We should also note that Medical Equipment industry companies like MicroPort Scientific commonly do use debt without problems. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making MicroPort Scientific 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. Over time, share prices tend to follow earnings per share, so if you're interested in MicroPort Scientific, you may well want to click here to check an interactive graph of its earnings per share history.
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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