Does Ramsay Health Care (ASX:RHC) Have A Healthy Balance Sheet?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We can see that Ramsay Health Care Limited (ASX:RHC) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Ramsay Health Care

What Is Ramsay Health Care's Debt?

As you can see below, Ramsay Health Care had AU$3.54b of debt at December 2020, down from AU$5.04b a year prior. On the flip side, it has AU$1.39b in cash leading to net debt of about AU$2.15b.

How Healthy Is Ramsay Health Care's Balance Sheet?

According to the last reported balance sheet, Ramsay Health Care had liabilities of AU$3.75b due within 12 months, and liabilities of AU$9.22b due beyond 12 months. Offsetting this, it had AU$1.39b in cash and AU$1.60b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$9.98b.

This deficit is considerable relative to its very significant market capitalization of AU$14.1b, so it does suggest shareholders should keep an eye on Ramsay Health Care'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 use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While we wouldn't worry about Ramsay Health Care's net debt to EBITDA ratio of 2.5, we think its super-low interest cover of 0.95 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Importantly, Ramsay Health Care's EBIT fell a jaw-dropping 68% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Ramsay Health Care 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Ramsay Health Care recorded free cash flow worth a fulsome 95% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Ramsay Health Care's EBIT growth rate and interest cover definitely weigh on it, in our esteem. 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 Ramsay Health Care commonly do use debt without problems. When we consider all the factors discussed, it seems to us that Ramsay Health Care is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. Case in point: We've spotted 3 warning signs for Ramsay Health Care you should be aware of, and 1 of them is a bit concerning.

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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