Is Instituto de Diagnóstico (SNSE:INDISA) Using Too Much Debt?

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.' 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. As with many other companies Instituto de Diagnóstico S.A. (SNSE:INDISA) makes use of debt. But should shareholders be worried about its use of debt?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Instituto de Diagnóstico

What Is Instituto de Diagnóstico's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Instituto de Diagnóstico had debt of CL$60.2b, up from CL$43.2b in one year. However, because it has a cash reserve of CL$21.1b, its net debt is less, at about CL$39.1b.

How Strong Is Instituto de Diagnóstico's Balance Sheet?

We can see from the most recent balance sheet that Instituto de Diagnóstico had liabilities of CL$57.5b falling due within a year, and liabilities of CL$40.7b due beyond that. On the other hand, it had cash of CL$21.1b and CL$50.3b worth of receivables due within a year. So its liabilities total CL$26.8b more than the combination of its cash and short-term receivables.

Given Instituto de Diagnóstico has a market capitalization of CL$218.4b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). 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 Instituto de Diagnóstico's debt to EBITDA ratio (4.0) suggests that it uses some debt, its interest cover is very weak, at 1.4, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Worse, Instituto de Diagnóstico's EBIT was down 75% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Instituto de Diagnóstico recorded free cash flow of 37% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On the face of it, Instituto de Diagnóstico's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its level of total liabilities is not so bad. It's also worth noting that Instituto de Diagnóstico is in the Healthcare industry, which is often considered to be quite defensive. Once we consider all the factors above, together, it seems to us that Instituto de Diagnóstico's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. To that end, you should learn about the 4 warning signs we've spotted with Instituto de Diagnóstico (including 2 which shouldn't be ignored) .

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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