Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Care Twentyone Corporation (TYO:2373) does carry debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, 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.
Check out our latest analysis for Care Twentyone
What Is Care Twentyone's Debt?
As you can see below, at the end of July 2020, Care Twentyone had JP¥5.98b of debt, up from JP¥4.30b a year ago. Click the image for more detail. However, it does have JP¥3.33b in cash offsetting this, leading to net debt of about JP¥2.65b.
A Look At Care Twentyone's Liabilities
According to the last reported balance sheet, Care Twentyone had liabilities of JP¥8.50b due within 12 months, and liabilities of JP¥23.0b due beyond 12 months. Offsetting these obligations, it had cash of JP¥3.33b as well as receivables valued at JP¥4.63b due within 12 months. So it has liabilities totalling JP¥23.5b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the JP¥11.5b 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. After all, Care Twentyone would likely require a major re-capitalisation if it had to pay its creditors today.
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.
Care Twentyone has a very low debt to EBITDA ratio of 0.92 so it is strange to see weak interest coverage, with last year's EBIT being only 2.2 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. Importantly, Care Twentyone grew its EBIT by 33% over the last twelve months, and that growth will make it easier to handle its 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 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, 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. During the last three years, Care Twentyone generated free cash flow amounting to a very robust 95% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Our View
Care Twentyone's level of total liabilities was a real negative on this analysis, as was its interest cover. But its conversion of EBIT to free cash flow was significantly redeeming. We would also note that Healthcare industry companies like Care Twentyone commonly do use debt without problems. Looking at all this data makes us feel a little cautious about Care Twentyone's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. To that end, you should learn about the 3 warning signs we've spotted with Care Twentyone (including 1 which is is potentially serious) .
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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This article by Simply Wall St is general in nature. 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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About TSE:2373
Slight second-rate dividend payer.
