The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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 note that Handicare Group AB (publ) (STO:HANDI) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Handicare Group’s Net Debt?
The chart below, which you can click on for greater detail, shows that Handicare Group had €105.9m in debt in March 2019; about the same as the year before. However, it does have €23.9m in cash offsetting this, leading to net debt of about €82.0m.
How Healthy Is Handicare Group’s Balance Sheet?
According to the last reported balance sheet, Handicare Group had liabilities of €54.6m due within 12 months, and liabilities of €138.4m due beyond 12 months. Offsetting these obligations, it had cash of €23.9m as well as receivables valued at €44.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €124.9m.
This is a mountain of leverage relative to its market capitalization of €208.0m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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.
Handicare Group has a debt to EBITDA ratio of 3.5 and its EBIT covered its interest expense 4.7 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Unfortunately, Handicare Group’s EBIT flopped 19% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Handicare Group’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Handicare Group recorded free cash flow of 31% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
We’d go so far as to say Handicare Group’s EBIT growth rate was disappointing. But at least its interest cover is not so bad. We should also note that Medical Equipment industry companies like Handicare Group commonly do use debt without problems. Overall, we think it’s fair to say that Handicare Group has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you’ve also come to that realization, you’re in luck, because today you can view this interactive graph of Handicare Group’s earnings per share history for free.
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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