Is ModivCare (NASDAQ:MODV) A Risky Investment?

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. As with many other companies ModivCare Inc. (NASDAQ:MODV) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for ModivCare

What Is ModivCare's Net Debt?

The chart below, which you can click on for greater detail, shows that ModivCare had US$979.4m in debt in December 2022; about the same as the year before. Net debt is about the same, since the it doesn't have much cash.

How Healthy Is ModivCare's Balance Sheet?

The latest balance sheet data shows that ModivCare had liabilities of US$491.6m due within a year, and liabilities of US$1.10b falling due after that. Offsetting these obligations, it had cash of US$14.5m as well as receivables valued at US$296.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.28b.

Given this deficit is actually higher than the company's market capitalization of US$1.12b, we think shareholders really should watch ModivCare's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). 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).

Weak interest cover of 1.1 times and a disturbingly high net debt to EBITDA ratio of 5.7 hit our confidence in ModivCare like a one-two punch to the gut. The debt burden here is substantial. Another concern for investors might be that ModivCare's EBIT fell 19% in the last year. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine ModivCare's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, ModivCare 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

To be frank both ModivCare's EBIT growth rate and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. We should also note that Healthcare industry companies like ModivCare commonly do use debt without problems. Overall, we think it's fair to say that ModivCare 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for ModivCare you should know about.

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.