Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Care Twentyone Corporation (TYO:2373) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Care Twentyone Carry?
The image below, which you can click on for greater detail, shows that at January 2021 Care Twentyone had debt of JP¥5.75b, up from JP¥4.80b in one year. However, it does have JP¥3.31b in cash offsetting this, leading to net debt of about JP¥2.44b.
How Strong Is Care Twentyone's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Care Twentyone had liabilities of JP¥8.52b due within 12 months and liabilities of JP¥23.4b due beyond that. Offsetting these obligations, it had cash of JP¥3.31b as well as receivables valued at JP¥4.72b due within 12 months. So it has liabilities totalling JP¥23.9b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the JP¥13.1b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Care Twentyone would probably need a major re-capitalization if its creditors were to demand repayment.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Given net debt is only 0.88 times EBITDA, it is initially surprising to see that Care Twentyone's EBIT has low interest coverage of 2.0 times. So one way or the other, it's clear the debt levels are not trivial. We saw Care Twentyone grow its EBIT by 6.0% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to 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 Care Twentyone 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Care Twentyone actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Neither Care Twentyone's ability to handle its total liabilities nor its interest cover gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. It's also worth noting that Care Twentyone is in the Healthcare industry, which is often considered to be quite defensive. When we consider all the factors discussed, it seems to us that Care Twentyone is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Care Twentyone is showing 2 warning signs in our investment analysis , and 1 of those is concerning...
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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