Aidigong Maternal & Child Health (HKG:286) Use Of Debt Could Be Considered Risky

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.' 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. Importantly, Aidigong Maternal & Child Health Limited (HKG:286) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Aidigong Maternal & Child Health

What Is Aidigong Maternal & Child Health's Debt?

As you can see below, at the end of June 2021, Aidigong Maternal & Child Health had HK$876.4m of debt, up from HK$772.1m a year ago. Click the image for more detail. On the flip side, it has HK$207.4m in cash leading to net debt of about HK$669.0m.

A Look At Aidigong Maternal & Child Health's Liabilities

According to the last reported balance sheet, Aidigong Maternal & Child Health had liabilities of HK$422.9m due within 12 months, and liabilities of HK$1.17b due beyond 12 months. Offsetting these obligations, it had cash of HK$207.4m as well as receivables valued at HK$293.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$1.09b.

While this might seem like a lot, it is not so bad since Aidigong Maternal & Child Health has a market capitalization of HK$3.86b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

While Aidigong Maternal & Child Health's debt to EBITDA ratio (4.9) suggests that it uses some debt, its interest cover is very weak, at 1.1, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Worse, Aidigong Maternal & Child Health's EBIT was down 43% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Aidigong Maternal & Child Health's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Aidigong Maternal & Child Health saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Aidigong Maternal & Child Health's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its level of total liabilities is not so bad. We should also note that Healthcare industry companies like Aidigong Maternal & Child Health commonly do use debt without problems. Overall, it seems to us that Aidigong Maternal & Child Health's balance sheet is really quite a risk to the business. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Aidigong Maternal & Child Health has 2 warning signs we think 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.
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