Is Five Star Senior Living (NASDAQ:FVE) Using Too Much Debt?

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. Importantly, Five Star Senior Living Inc. (NASDAQ:FVE) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Five Star Senior Living

How Much Debt Does Five Star Senior Living Carry?

The image below, which you can click on for greater detail, shows that Five Star Senior Living had debt of US$7.26m at the end of September 2020, a reduction from US$7.62m over a year. But on the other hand it also has US$105.2m in cash, leading to a US$98.0m 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$171.9m due within 12 months, and liabilities of US$64.8m due beyond 12 months. Offsetting these obligations, it had cash of US$105.2m as well as receivables valued at US$89.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$42.0m.

Of course, Five Star Senior Living has a market capitalization of US$227.3m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. 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!

It was also good to see that despite losing money on the EBIT line last year, Five Star Senior Living turned things around in the last 12 months, delivering and EBIT of US$22m. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Five Star Senior Living'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.

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 recorded free cash flow worth a fulsome 97% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing up

Although Five Star Senior Living's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$98.0m. And it impressed us with free cash flow of US$22m, being 97% of its EBIT. So is Five Star Senior Living'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. Take risks, for example - Five Star Senior Living has 2 warning signs we think you should be aware of.

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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