These 4 Measures Indicate That Rici Healthcare Holdings (HKG:1526) Is Using Debt Extensively

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Rici Healthcare Holdings Limited (HKG:1526) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Rici Healthcare Holdings

What Is Rici Healthcare Holdings's Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Rici Healthcare Holdings had debt of CN¥1.38b, up from CN¥983.7m in one year. However, it also had CN¥574.9m in cash, and so its net debt is CN¥804.6m.

How Healthy Is Rici Healthcare Holdings' Balance Sheet?

We can see from the most recent balance sheet that Rici Healthcare Holdings had liabilities of CN¥1.95b falling due within a year, and liabilities of CN¥1.93b due beyond that. Offsetting this, it had CN¥574.9m in cash and CN¥302.7m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥3.00b.

This deficit casts a shadow over the CN¥1.65b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Rici Healthcare Holdings would probably need a major re-capitalization if its creditors were to demand repayment.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While we wouldn't worry about Rici Healthcare Holdings's net debt to EBITDA ratio of 3.4, we think its super-low interest cover of 0.47 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. One redeeming factor for Rici Healthcare Holdings is that it turned last year's EBIT loss into a gain of CN¥75m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Rici Healthcare Holdings's earnings that will influence how the balance sheet holds up in the future. 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Rici Healthcare Holdings actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

To be frank both Rici Healthcare Holdings's interest cover 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. We should also note that Healthcare industry companies like Rici Healthcare Holdings commonly do use debt without problems. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Rici Healthcare Holdings stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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, we've discovered 2 warning signs for Rici Healthcare Holdings (1 is potentially serious!) that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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