These 4 Measures Indicate That Pacific Hospital Supply (GTSM:4126) Is Using Debt Safely

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 Pacific Hospital Supply Co., Ltd (GTSM:4126) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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. 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.

View our latest analysis for Pacific Hospital Supply

What Is Pacific Hospital Supply's Net Debt?

The image below, which you can click on for greater detail, shows that Pacific Hospital Supply had debt of NT$485.0m at the end of September 2020, a reduction from NT$860.0m over a year. However, its balance sheet shows it holds NT$498.2m in cash, so it actually has NT$13.2m net cash.

A Look At Pacific Hospital Supply's Liabilities

Zooming in on the latest balance sheet data, we can see that Pacific Hospital Supply had liabilities of NT$482.9m due within 12 months and liabilities of NT$860.4m due beyond that. Offsetting these obligations, it had cash of NT$498.2m as well as receivables valued at NT$172.1m due within 12 months. So it has liabilities totalling NT$673.0m more than its cash and near-term receivables, combined.

Since publicly traded Pacific Hospital Supply shares are worth a total of NT$4.94b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Pacific Hospital Supply boasts net cash, so it's fair to say it does not have a heavy debt load!

And we also note warmly that Pacific Hospital Supply grew its EBIT by 10% last year, making its debt load easier to handle. 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 Pacific Hospital Supply 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 company can only pay off debt with cold hard cash, not accounting profits. Pacific Hospital Supply may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Pacific Hospital Supply recorded free cash flow worth 67% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While Pacific Hospital Supply does have more liabilities than liquid assets, it also has net cash of NT$13.2m. And it impressed us with free cash flow of NT$352m, being 67% of its EBIT. So is Pacific Hospital Supply's debt a risk? It doesn't seem so to us. 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. Be aware that Pacific Hospital Supply is showing 2 warning signs in our investment analysis , you should know about...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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