Estia Health (ASX:EHE) Takes On Some Risk With Its Use Of Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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, Estia Health Limited (ASX:EHE) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Estia Health

What Is Estia Health's Debt?

The image below, which you can click on for greater detail, shows that Estia Health had debt of AU$28.8m at the end of December 2021, a reduction from AU$104.9m over a year. However, it also had AU$23.3m in cash, and so its net debt is AU$5.51m.

A Look At Estia Health's Liabilities

The latest balance sheet data shows that Estia Health had liabilities of AU$1.04b due within a year, and liabilities of AU$190.6m falling due after that. On the other hand, it had cash of AU$23.3m and AU$12.4m worth of receivables due within a year. So it has liabilities totalling AU$1.19b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the AU$594.1m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Estia Health would probably need a major re-capitalization if its creditors were to demand repayment. Estia Health may have virtually no net debt, but it does have a lot of liabilities.

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.

Estia Health has a net debt to EBITDA ratio of 0.048, suggesting a very conservative balance sheet. But strangely, EBIT was only 1.2 times interest expenses, suggesting the that may paint an overly pretty picture of the stock. Unfortunately, Estia Health saw its EBIT slide 8.8% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Estia Health's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Estia Health produced sturdy free cash flow equating to 55% 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.

Our View

On the face of it, Estia Health's interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. We should also note that Healthcare industry companies like Estia Health commonly do use debt without problems. Overall, we think it's fair to say that Estia Health has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Estia Health (1 is potentially serious) you should be aware of.

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.

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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.