Is Humana (STO:HUM) Using Too Much Debt?

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. As with many other companies Humana AB (publ) (STO:HUM) makes use of debt. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Our analysis indicates that HUM is potentially undervalued!

What Is Humana's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2022 Humana had debt of kr2.20b, up from kr2.05b in one year. However, it also had kr660.0m in cash, and so its net debt is kr1.54b.

How Strong Is Humana's Balance Sheet?

The latest balance sheet data shows that Humana had liabilities of kr2.06b due within a year, and liabilities of kr4.83b falling due after that. Offsetting these obligations, it had cash of kr660.0m as well as receivables valued at kr1.18b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr5.05b.

This deficit casts a shadow over the kr2.01b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Humana would probably need a major re-capitalization if its creditors were to demand repayment.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Humana has a debt to EBITDA ratio of 3.1 and its EBIT covered its interest expense 2.9 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. More concerning, Humana saw its EBIT drop by 8.1% in the last twelve months. 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Humana can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Humana actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

We'd go so far as to say Humana's level of total liabilities was disappointing. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. It's also worth noting that Humana is in the Healthcare industry, which is often considered to be quite defensive. Overall, we think it's fair to say that Humana has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Humana (1 makes us a bit uncomfortable!) that you should be aware of before investing here.

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.