Here's Why Zenicor Medical Systems (NGM:ZENI) Has A Meaningful Debt Burden

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.' 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 Zenicor Medical Systems AB (publ) (NGM:ZENI) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 the opportunities and risks within the SE Medical Equipment industry.

What Is Zenicor Medical Systems's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2022 Zenicor Medical Systems had debt of kr17.3m, up from kr9.05m in one year. However, it also had kr2.14m in cash, and so its net debt is kr15.2m.

How Strong Is Zenicor Medical Systems' Balance Sheet?

We can see from the most recent balance sheet that Zenicor Medical Systems had liabilities of kr13.3m falling due within a year, and liabilities of kr14.5m due beyond that. Offsetting these obligations, it had cash of kr2.14m as well as receivables valued at kr2.46m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr23.2m.

While this might seem like a lot, it is not so bad since Zenicor Medical Systems has a market capitalization of kr101.2m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 11.1 hit our confidence in Zenicor Medical Systems like a one-two punch to the gut. The debt burden here is substantial. Notably, Zenicor Medical Systems's EBIT was pretty flat over the last year, which isn't ideal given the debt load. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Zenicor Medical Systems 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Zenicor Medical Systems saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Zenicor Medical Systems's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its level of total liabilities is not so bad. It's also worth noting that Zenicor Medical Systems is in the Medical Equipment industry, which is often considered to be quite defensive. Looking at the bigger picture, it seems clear to us that Zenicor Medical Systems's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. We've identified 6 warning signs with Zenicor Medical Systems (at least 4 which make us uncomfortable) , 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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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.