We Think CVS Group (LON:CVSG) Can Stay On Top Of Its Debt

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. We can see that CVS Group plc (LON:CVSG) does use debt in its business. But the real question is whether this debt is making the company risky.

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. 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. 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.

Check out our latest analysis for CVS Group

What Is CVS Group's Debt?

The image below, which you can click on for greater detail, shows that CVS Group had debt of UK£83.7m at the end of December 2020, a reduction from UK£103.7m over a year. However, it also had UK£40.6m in cash, and so its net debt is UK£43.1m.

How Strong Is CVS Group's Balance Sheet?

The latest balance sheet data shows that CVS Group had liabilities of UK£114.3m due within a year, and liabilities of UK£195.9m falling due after that. On the other hand, it had cash of UK£40.6m and UK£44.5m worth of receivables due within a year. So its liabilities total UK£225.1m more than the combination of its cash and short-term receivables.

Of course, CVS Group has a market capitalization of UK£1.38b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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 CVS Group's low debt to EBITDA ratio of 0.76 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.1 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. CVS Group grew its EBIT by 4.7% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if CVS Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. Happily for any shareholders, CVS Group actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

The good news is that CVS Group's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But we must concede we find its interest cover has the opposite effect. We would also note that Healthcare industry companies like CVS Group commonly do use debt without problems. Taking all this data into account, it seems to us that CVS Group takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - CVS Group has 1 warning sign we think you should be aware of.

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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