Estia Health (ASX:EHE) Use Of Debt Could Be Considered Risky

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.' 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. We note that Estia Health Limited (ASX:EHE) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Estia Health

What Is Estia Health's Net Debt?

The image below, which you can click on for greater detail, shows that Estia Health had debt of AU$104.9m at the end of December 2020, a reduction from AU$116.3m over a year. However, because it has a cash reserve of AU$19.0m, its net debt is less, at about AU$85.9m.

A Look At Estia Health's Liabilities

According to the last reported balance sheet, Estia Health had liabilities of AU$1.01b due within 12 months, and liabilities of AU$272.6m due beyond 12 months. Offsetting these obligations, it had cash of AU$19.0m as well as receivables valued at AU$7.33m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$1.26b.

The deficiency here weighs heavily on the AU$611.4m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Estia Health would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Estia Health has a very low debt to EBITDA ratio of 0.82 so it is strange to see weak interest coverage, with last year's EBIT being only 1.5 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. Unfortunately, Estia Health's EBIT flopped 11% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Estia 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Estia Health reported free cash flow worth 20% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

To be frank both Estia Health's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. We should also note that Healthcare industry companies like Estia Health commonly do use debt without problems. Overall, it seems to us that Estia Health's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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 example - Estia Health has 1 warning sign we think 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. 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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