Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Capitol Health Limited (ASX:CAJ) does carry debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Capitol Health's Net Debt?
The image below, which you can click on for greater detail, shows that Capitol Health had debt of AU$17.0m at the end of December 2020, a reduction from AU$43.8m over a year. But it also has AU$19.0m in cash to offset that, meaning it has AU$2.05m net cash.
How Healthy Is Capitol Health's Balance Sheet?
We can see from the most recent balance sheet that Capitol Health had liabilities of AU$39.7m falling due within a year, and liabilities of AU$81.9m due beyond that. Offsetting these obligations, it had cash of AU$19.0m as well as receivables valued at AU$4.61m due within 12 months. So it has liabilities totalling AU$97.9m more than its cash and near-term receivables, combined.
This deficit isn't so bad because Capitol Health is worth AU$364.8m, and thus could probably raise enough capital to shore up 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. While it does have liabilities worth noting, Capitol Health also has more cash than debt, so we're pretty confident it can manage its debt safely.
In addition to that, we're happy to report that Capitol Health has boosted its EBIT by 78%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Capitol Health 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. Capitol Health may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Capitol Health recorded free cash flow worth a fulsome 93% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
While Capitol Health does have more liabilities than liquid assets, it also has net cash of AU$2.05m. And it impressed us with free cash flow of AU$34m, being 93% of its EBIT. So is Capitol Health's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 4 warning signs with Capitol Health , and understanding them should be part of your investment process.
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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