Is Wenzhou Kangning Hospital (HKG:2120) Using Too Much Debt?

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.' 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 note that Wenzhou Kangning Hospital Co., Ltd. (HKG:2120) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Wenzhou Kangning Hospital

What Is Wenzhou Kangning Hospital's Net Debt?

As you can see below, at the end of June 2021, Wenzhou Kangning Hospital had CN¥564.6m of debt, up from CN¥476.3m a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥310.1m, its net debt is less, at about CN¥254.5m.

A Look At Wenzhou Kangning Hospital's Liabilities

Zooming in on the latest balance sheet data, we can see that Wenzhou Kangning Hospital had liabilities of CN¥554.2m due within 12 months and liabilities of CN¥484.6m due beyond that. Offsetting this, it had CN¥310.1m in cash and CN¥416.1m in receivables that were due within 12 months. So its liabilities total CN¥312.5m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Wenzhou Kangning Hospital is worth CN¥1.45b, 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.

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

While Wenzhou Kangning Hospital's low debt to EBITDA ratio of 1.3 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.7 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. On top of that, Wenzhou Kangning Hospital grew its EBIT by 91% over the last twelve months, and that growth will make it easier to handle its debt. 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 Wenzhou Kangning Hospital's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Wenzhou Kangning Hospital burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Wenzhou Kangning Hospital's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to grow its EBIT is pretty flash. We would also note that Healthcare industry companies like Wenzhou Kangning Hospital commonly do use debt without problems. Considering this range of data points, we think Wenzhou Kangning Hospital is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Wenzhou Kangning Hospital , and understanding them should be part of your investment process.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.