These 4 Measures Indicate That Modern Dental Group (HKG:3600) Is Using Debt Reasonably Well

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. As with many other companies Modern Dental Group Limited (HKG:3600) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Modern Dental Group

How Much Debt Does Modern Dental Group Carry?

As you can see below, Modern Dental Group had HK$592.3m of debt at June 2022, down from HK$717.7m a year prior. However, it does have HK$413.8m in cash offsetting this, leading to net debt of about HK$178.5m.

How Strong Is Modern Dental Group's Balance Sheet?

We can see from the most recent balance sheet that Modern Dental Group had liabilities of HK$930.9m falling due within a year, and liabilities of HK$255.1m due beyond that. Offsetting this, it had HK$413.8m in cash and HK$592.0m in receivables that were due within 12 months. So its liabilities total HK$180.2m more than the combination of its cash and short-term receivables.

Of course, Modern Dental Group has a market capitalization of HK$1.77b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Modern Dental Group has a low net debt to EBITDA ratio of only 0.42. And its EBIT easily covers its interest expense, being 20.6 times the size. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for Modern Dental Group if management cannot prevent a repeat of the 38% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Modern Dental Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Modern Dental Group recorded free cash flow worth a fulsome 84% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Modern Dental Group's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But we must concede we find its EBIT growth rate has the opposite effect. It's also worth noting that Modern Dental Group is in the Medical Equipment industry, which is often considered to be quite defensive. Taking all this data into account, it seems to us that Modern Dental Group takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Modern Dental Group is showing 3 warning signs in our investment analysis , you should know about...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.