Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘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. As with many other companies Mercator Medical S.A. (WSE:MRC) makes use of debt. But the real question is whether this debt is making the company risky.
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Mercator Medical’s Net Debt?
The image below, which you can click on for greater detail, shows that at March 2020 Mercator Medical had debt of zł142.1m, up from zł133.4m in one year. However, it does have zł14.9m in cash offsetting this, leading to net debt of about zł127.2m.
How Strong Is Mercator Medical’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Mercator Medical had liabilities of zł163.0m due within 12 months and liabilities of zł91.4m due beyond that. Offsetting this, it had zł14.9m in cash and zł109.7m in receivables that were due within 12 months. So it has liabilities totalling zł129.9m more than its cash and near-term receivables, combined.
Of course, Mercator Medical has a market capitalization of zł3.46b, so these liabilities are probably manageable. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Mercator Medical’s net debt is sitting at a very reasonable 2.3 times its EBITDA, while its EBIT covered its interest expense just 5.6 times last year. While these numbers do not alarm us, it’s worth noting that the cost of the company’s debt is having a real impact. Notably, Mercator Medical’s EBIT launched higher than Elon Musk, gaining a whopping 424% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Mercator Medical’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
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. Over the last three years, Mercator Medical saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Mercator Medical’s conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its EBIT growth rate. It’s also worth noting that Mercator Medical is in the Medical Equipment industry, which is often considered to be quite defensive. Considering this range of data points, we think Mercator Medical is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Mercator Medical is showing 3 warning signs in our investment analysis , and 2 of those are potentially serious…
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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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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