Medical Imaging (GTSM:6637) Seems To Use Debt Quite Sensibly

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.' 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 can see that Medical Imaging Corporation (GTSM:6637) does use debt in its business. But should shareholders be worried about its use of debt?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Medical Imaging

What Is Medical Imaging's Net Debt?

As you can see below, at the end of June 2020, Medical Imaging had NT$203.2m of debt, up from NT$171.5m a year ago. Click the image for more detail. However, it does have NT$141.4m in cash offsetting this, leading to net debt of about NT$61.7m.

How Strong Is Medical Imaging's Balance Sheet?

The latest balance sheet data shows that Medical Imaging had liabilities of NT$293.3m due within a year, and liabilities of NT$144.2m falling due after that. On the other hand, it had cash of NT$141.4m and NT$90.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$205.4m.

Of course, Medical Imaging has a market capitalization of NT$1.20b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). 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).

Medical Imaging has a low debt to EBITDA ratio of only 0.39. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. On the other hand, Medical Imaging saw its EBIT drop by 6.1% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But it is Medical Imaging's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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, Medical Imaging reported free cash flow worth 4.8% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Medical Imaging's interest cover was a real positive on this analysis, as was its net debt to EBITDA. But truth be told its conversion of EBIT to free cash flow had us nibbling our nails. We would also note that Healthcare industry companies like Medical Imaging commonly do use debt without problems. When we consider all the elements mentioned above, it seems to us that Medical Imaging is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Medical Imaging 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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