Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Medicon Hellas S.A. (ATH:MEDIC) makes use of debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Medicon Hellas's Debt?
As you can see below, Medicon Hellas had €12.1m of debt at December 2020, down from €13.2m a year prior. However, it does have €7.20m in cash offsetting this, leading to net debt of about €4.91m.
How Healthy Is Medicon Hellas' Balance Sheet?
We can see from the most recent balance sheet that Medicon Hellas had liabilities of €3.91m falling due within a year, and liabilities of €13.0m due beyond that. On the other hand, it had cash of €7.20m and €6.59m worth of receivables due within a year. So its liabilities total €3.13m more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Medicon Hellas is worth €10.1m, 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.
Medicon Hellas's net debt to EBITDA ratio of about 2.0 suggests only moderate use of debt. And its strong interest cover of 21.9 times, makes us even more comfortable. It is well worth noting that Medicon Hellas's EBIT shot up like bamboo after rain, gaining 44% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Medicon Hellas's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Medicon Hellas generated free cash flow amounting to a very robust 95% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
The good news is that Medicon Hellas's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! We would also note that Medical Equipment industry companies like Medicon Hellas commonly do use debt without problems. Zooming out, Medicon Hellas seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. For instance, we've identified 3 warning signs for Medicon Hellas (1 doesn't sit too well with us) you should be aware of.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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