Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. As with many other companies Korian (EPA:KORI) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Korian Carry?
The image below, which you can click on for greater detail, shows that at December 2020 Korian had debt of €4.04b, up from €2.89b in one year. However, it does have €1.16b in cash offsetting this, leading to net debt of about €2.88b.
How Healthy Is Korian's Balance Sheet?
According to the last reported balance sheet, Korian had liabilities of €2.61b due within 12 months, and liabilities of €7.26b due beyond 12 months. On the other hand, it had cash of €1.16b and €623.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €8.09b.
The deficiency here weighs heavily on the €3.23b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Korian would probably need a major re-capitalization if its creditors were to demand repayment.
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).
Weak interest cover of 1.2 times and a disturbingly high net debt to EBITDA ratio of 7.3 hit our confidence in Korian like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, Korian's EBIT was down 37% 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. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Korian'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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, Korian recorded free cash flow worth a fulsome 94% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
To be frank both Korian's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. It's also worth noting that Korian is in the Healthcare industry, which is often considered to be quite defensive. We're quite clear that we consider Korian to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Korian is showing 4 warning signs in our investment analysis , and 1 of those can't be ignored...
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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