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. 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. We note that Abano Healthcare Group Limited (NZSE:ABA) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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, 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 Abano Healthcare Group Carry?
You can click the graphic below for the historical numbers, but it shows that as of May 2019 Abano Healthcare Group had NZ$146.1m of debt, an increase on NZ$100.8m, over one year. However, it also had NZ$3.13m in cash, and so its net debt is NZ$143.0m.
How Strong Is Abano Healthcare Group's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Abano Healthcare Group had liabilities of NZ$33.3m due within 12 months and liabilities of NZ$156.8m due beyond that. Offsetting these obligations, it had cash of NZ$3.13m as well as receivables valued at NZ$12.3m due within 12 months. So it has liabilities totalling NZ$174.6m more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company's NZ$122.2m market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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).
Abano Healthcare Group has a debt to EBITDA ratio of 4.5 and its EBIT covered its interest expense 3.7 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Even more troubling is the fact that Abano Healthcare Group actually let its EBIT decrease by 7.3% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Abano Healthcare 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, 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. Looking at the most recent three years, Abano Healthcare Group recorded free cash flow of 39% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
To be frank both Abano Healthcare Group's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. Having said that, its ability to convert EBIT to free cash flow isn't such a worry. It's also worth noting that Abano Healthcare Group is in the Healthcare industry, which is often considered to be quite defensive. Overall, it seems to us that Abano Healthcare Group's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Abano Healthcare Group's dividend history, without delay!
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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