Wenzhou Kangning Hospital (HKG:2120) Has A Somewhat Strained Balance Sheet

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Wenzhou Kangning Hospital Co., Ltd. (HKG:2120) does use debt in its business. But should shareholders be worried about its use of debt?

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Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Wenzhou Kangning Hospital's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2024 Wenzhou Kangning Hospital had CN¥954.9m of debt, an increase on CN¥874.6m, over one year. However, because it has a cash reserve of CN¥269.7m, its net debt is less, at about CN¥685.2m.

How Healthy Is Wenzhou Kangning Hospital's Balance Sheet?

According to the last reported balance sheet, Wenzhou Kangning Hospital had liabilities of CN¥694.4m due within 12 months, and liabilities of CN¥967.3m due beyond 12 months. Offsetting this, it had CN¥269.7m in cash and CN¥653.8m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥738.1m.

Given this deficit is actually higher than the company's market capitalization of CN¥650.6m, we think shareholders really should watch Wenzhou Kangning Hospital's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

Check out our latest analysis for Wenzhou Kangning Hospital

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Wenzhou Kangning Hospital has a debt to EBITDA ratio of 2.9 and its EBIT covered its interest expense 3.2 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Even more troubling is the fact that Wenzhou Kangning Hospital actually let its EBIT decrease by 3.0% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Wenzhou Kangning Hospital will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Considering the last three years, Wenzhou Kangning Hospital actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

To be frank both Wenzhou Kangning Hospital's level of total liabilities and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. We should also note that Healthcare industry companies like Wenzhou Kangning Hospital commonly do use debt without problems. We're quite clear that we consider Wenzhou Kangning Hospital 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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for Wenzhou Kangning Hospital (1 shouldn't be ignored) you should be aware of.

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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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.