Five Star Senior Living (NASDAQ:FVE) Seems To Use Debt Quite Sensibly

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.' 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. We note that Five Star Senior Living Inc. (NASDAQ:FVE) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 Five Star Senior Living

How Much Debt Does Five Star Senior Living Carry?

As you can see below, Five Star Senior Living had US$7.17m of debt at December 2020, down from US$7.53m a year prior. But on the other hand it also has US$93.2m in cash, leading to a US$86.0m net cash position.

How Healthy Is Five Star Senior Living's Balance Sheet?

According to the last reported balance sheet, Five Star Senior Living had liabilities of US$177.9m due within 12 months, and liabilities of US$65.8m due beyond 12 months. Offsetting these obligations, it had cash of US$93.2m as well as receivables valued at US$105.5m due within 12 months. So its liabilities total US$45.0m more than the combination of its cash and short-term receivables.

Five Star Senior Living has a market capitalization of US$173.9m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Despite its noteworthy liabilities, Five Star Senior Living boasts net cash, so it's fair to say it does not have a heavy debt load!

Although Five Star Senior Living made a loss at the EBIT level, last year, it was also good to see that it generated US$16m in EBIT over the last twelve months. 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 Five Star Senior Living 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Five Star Senior Living 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 last year, Five Star Senior Living actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

While Five Star Senior Living does have more liabilities than liquid assets, it also has net cash of US$86.0m. And it impressed us with free cash flow of US$46m, being 280% of its EBIT. So is Five Star Senior Living's debt a risk? It doesn't seem so to us. 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 1 warning sign for Five Star Senior Living that you should be aware of before investing here.

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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