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

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 can see that Instituto de Diagnóstico S.A. (SNSE:INDISA) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Instituto de Diagnóstico

What Is Instituto de Diagnóstico's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2022 Instituto de Diagnóstico had CL$91.8b of debt, an increase on CL$59.4b, over one year. However, it does have CL$15.9b in cash offsetting this, leading to net debt of about CL$75.8b.

How Strong Is Instituto de Diagnóstico's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Instituto de Diagnóstico had liabilities of CL$115.9b due within 12 months and liabilities of CL$42.9b due beyond that. On the other hand, it had cash of CL$15.9b and CL$74.3b worth of receivables due within a year. So its liabilities total CL$68.5b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Instituto de Diagnóstico has a market capitalization of CL$197.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Instituto de Diagnóstico has net debt to EBITDA of 2.7 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 8.9 times its interest expense, and its net debt to EBITDA, was quite high, at 2.7. Notably, Instituto de Diagnóstico's EBIT launched higher than Elon Musk, gaining a whopping 145% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Instituto de Diagnóstico will need earnings to service that debt. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Instituto de Diagnóstico burned a lot of cash. 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. When we consider all the factors mentioned above, we do feel a bit cautious about Instituto de Diagnóstico's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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, we've discovered 3 warning signs for Instituto de Diagnóstico (2 make us uncomfortable!) that you should be aware of before investing here.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.