Here's Why Instituto de Diagnóstico (SNSE:INDISA) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that Instituto de Diagnóstico S.A. (SNSE:INDISA) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Instituto de Diagnóstico

What Is Instituto de Diagnóstico's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2021 Instituto de Diagnóstico had debt of CL$76.3b, up from CL$55.8b in one year. However, it does have CL$9.75b in cash offsetting this, leading to net debt of about CL$66.6b.

How Strong Is Instituto de Diagnóstico's Balance Sheet?

The latest balance sheet data shows that Instituto de Diagnóstico had liabilities of CL$95.9b due within a year, and liabilities of CL$39.8b falling due after that. Offsetting these obligations, it had cash of CL$9.75b as well as receivables valued at CL$72.1b due within 12 months. So its liabilities total CL$53.9b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Instituto de Diagnóstico is worth CL$177.0b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a debt to EBITDA ratio of 2.4, Instituto de Diagnóstico uses debt artfully but responsibly. And the alluring interest cover (EBIT of 8.8 times interest expense) certainly does not do anything to dispel this impression. Notably, Instituto de Diagnóstico's EBIT launched higher than Elon Musk, gaining a whopping 312% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is Instituto de Diagnóstico's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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. Over the last three years, Instituto de Diagnóstico saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Instituto de Diagnóstico's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to grow its EBIT is pretty flash. We would also note that Healthcare industry companies like Instituto de Diagnóstico commonly do use debt without problems. Looking at all this data makes us feel a little cautious about Instituto de Diagnóstico's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 4 warning signs with Instituto de Diagnóstico (at least 3 which are significant) , and understanding them should be part of your investment process.

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.