Does Hospital Corporation of China (HKG:3869) Have A Healthy Balance Sheet?

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 Hospital Corporation of China Limited (HKG:3869) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Hospital Corporation of China

What Is Hospital Corporation of China's Net Debt?

The image below, which you can click on for greater detail, shows that Hospital Corporation of China had debt of CN¥1.69b at the end of December 2020, a reduction from CN¥1.91b over a year. However, it also had CN¥951.5m in cash, and so its net debt is CN¥738.5m.

How Strong Is Hospital Corporation of China's Balance Sheet?

We can see from the most recent balance sheet that Hospital Corporation of China had liabilities of CN¥481.1m falling due within a year, and liabilities of CN¥1.90b due beyond that. Offsetting this, it had CN¥951.5m in cash and CN¥307.9m in receivables that were due within 12 months. So its liabilities total CN¥1.12b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥1.43b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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

Hospital Corporation of China's net debt is 2.8 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 187 is very high, suggesting that the interest expense on the debt is currently quite low. Also relevant is that Hospital Corporation of China has grown its EBIT by a very respectable 28% in the last year, thus enhancing its ability to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Hospital Corporation of China will need earnings to service that debt. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Hospital Corporation of China's free cash flow amounted to 32% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Both Hospital Corporation of China's ability to to cover its interest expense with its EBIT and its EBIT growth rate gave us comfort that it can handle its debt. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. We would also note that Healthcare industry companies like Hospital Corporation of China commonly do use debt without problems. Considering this range of data points, we think Hospital Corporation of China is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. We've identified 1 warning sign with Hospital Corporation of China , and understanding them should be part of your investment process.

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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