Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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. As with many other companies Thomson Medical Group Limited (SGX:A50) makes use of debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Thomson Medical Group’s Debt?
The chart below, which you can click on for greater detail, shows that Thomson Medical Group had S$575.6m in debt in December 2019; about the same as the year before. On the flip side, it has S$119.8m in cash leading to net debt of about S$455.8m.
How Strong Is Thomson Medical Group’s Balance Sheet?
According to the last reported balance sheet, Thomson Medical Group had liabilities of S$95.8m due within 12 months, and liabilities of S$585.5m due beyond 12 months. Offsetting this, it had S$119.8m in cash and S$24.7m in receivables that were due within 12 months. So its liabilities total S$536.7m more than the combination of its cash and short-term receivables.
Thomson Medical Group has a market capitalization of S$1.59b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Thomson Medical Group shareholders face the double whammy of a high net debt to EBITDA ratio (8.1), and fairly weak interest coverage, since EBIT is just 1.7 times the interest expense. This means we’d consider it to have a heavy debt load. Fortunately, Thomson Medical Group grew its EBIT by 4.9% in the last year, slowly shrinking its debt relative to earnings. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Thomson Medical Group’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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Thomson Medical Group produced sturdy free cash flow equating to 50% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Both Thomson Medical Group’s net debt to EBITDA and its interest cover were discouraging. But its not so bad at growing its EBIT. It’s also worth noting that Thomson Medical Group is in the Healthcare industry, which is often considered to be quite defensive. We think that Thomson Medical Group’s debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. Take risks, for example – Thomson Medical Group has 4 warning signs (and 2 which shouldn’t be ignored) we think you should know about.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
If you spot an error that warrants correction, please contact the editor at email@example.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.
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. Thank you for reading.