Capitol Health (ASX:CAJ) Takes On Some Risk With Its Use Of Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Capitol Health Limited (ASX:CAJ) does carry debt. But is this debt a concern to shareholders?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Capitol Health

What Is Capitol Health's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Capitol Health had AU$72.8m of debt, an increase on AU$19.0m, over one year. However, because it has a cash reserve of AU$19.2m, its net debt is less, at about AU$53.6m.

How Healthy Is Capitol Health's Balance Sheet?

We can see from the most recent balance sheet that Capitol Health had liabilities of AU$48.4m falling due within a year, and liabilities of AU$131.7m due beyond that. Offsetting this, it had AU$19.2m in cash and AU$5.99m in receivables that were due within 12 months. So it has liabilities totalling AU$154.9m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of AU$249.8m, so it does suggest shareholders should keep an eye on Capitol Health's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Capitol Health's net debt is sitting at a very reasonable 1.9 times its EBITDA, while its EBIT covered its interest expense just 3.2 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Shareholders should be aware that Capitol Health's EBIT was down 23% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Capitol Health can strengthen its balance sheet over time. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Capitol Health actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Neither Capitol Health's ability to grow its EBIT nor its interest cover gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. We should also note that Healthcare industry companies like Capitol Health commonly do use debt without problems. Looking at all the angles mentioned above, it does seem to us that Capitol Health is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Capitol Health you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.