Oncoclínicas do Brasil Serviços Médicos (BVMF:ONCO3) Takes On Some Risk With Its Use Of Debt

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. As with many other companies Oncoclínicas do Brasil Serviços Médicos S.A. (BVMF:ONCO3) makes use of debt. 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. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Oncoclínicas do Brasil Serviços Médicos

What Is Oncoclínicas do Brasil Serviços Médicos's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Oncoclínicas do Brasil Serviços Médicos had debt of R$4.37b, up from R$3.49b in one year. However, it does have R$412.8m in cash offsetting this, leading to net debt of about R$3.96b.

How Healthy Is Oncoclínicas do Brasil Serviços Médicos' Balance Sheet?

According to the last reported balance sheet, Oncoclínicas do Brasil Serviços Médicos had liabilities of R$2.50b due within 12 months, and liabilities of R$4.59b due beyond 12 months. Offsetting this, it had R$412.8m in cash and R$2.40b in receivables that were due within 12 months. So it has liabilities totalling R$4.28b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of R$4.32b, so it does suggest shareholders should keep an eye on Oncoclínicas do Brasil Serviços Médicos' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). 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).

While Oncoclínicas do Brasil Serviços Médicos's debt to EBITDA ratio (4.4) suggests that it uses some debt, its interest cover is very weak, at 1.5, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. On a slightly more positive note, Oncoclínicas do Brasil Serviços Médicos grew its EBIT at 20% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Oncoclínicas do Brasil Serviços Médicos's ability to maintain a healthy balance sheet going forward. 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Oncoclínicas do Brasil Serviços Médicos saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Oncoclínicas do Brasil Serviços Médicos's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. We should also note that Healthcare industry companies like Oncoclínicas do Brasil Serviços Médicos commonly do use debt without problems. Looking at the bigger picture, it seems clear to us that Oncoclínicas do Brasil Serviços Médicos's use of debt is creating risks for the company. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Oncoclínicas do Brasil Serviços Médicos is showing 3 warning signs in our investment analysis , and 2 of those are significant...

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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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.