Is Estia Health (ASX:EHE) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Estia Health Limited (ASX:EHE) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Estia Health

How Much Debt Does Estia Health Carry?

As you can see below, Estia Health had AU$130.0m of debt, at June 2020, which is about the same as the year before. You can click the chart for greater detail. However, it also had AU$30.6m in cash, and so its net debt is AU$99.4m.

A Look At Estia Health's Liabilities

Zooming in on the latest balance sheet data, we can see that Estia Health had liabilities of AU$960.3m due within 12 months and liabilities of AU$301.3m due beyond that. Offsetting this, it had AU$30.6m in cash and AU$8.13m in receivables that were due within 12 months. So its liabilities total AU$1.22b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the AU$457.3m company, like a colossus towering over mere mortals. 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

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 1.8 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. Importantly, Estia Health grew its EBIT by 31% over the last twelve months, and that growth will make it easier to handle its debt. 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 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.

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. During the last three years, Estia Health produced sturdy free cash flow equating to 53% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Estia Health's level of total liabilities and interest cover definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. We should also note that Healthcare industry companies like Estia Health commonly do use debt without problems. Taking the abovementioned factors together we do think Estia Health's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Estia Health that you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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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