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. As with many other companies Centene Corporation (NYSE:CNC) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Centene's Net Debt?
The chart below, which you can click on for greater detail, shows that Centene had US$16.6b in debt in June 2021; about the same as the year before. However, it does have US$12.6b in cash offsetting this, leading to net debt of about US$4.03b.
How Strong Is Centene's Balance Sheet?
We can see from the most recent balance sheet that Centene had liabilities of US$23.6b falling due within a year, and liabilities of US$21.8b due beyond that. On the other hand, it had cash of US$12.6b and US$11.2b worth of receivables due within a year. So its liabilities total US$21.6b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its very significant market capitalization of US$34.8b, so it does suggest shareholders should keep an eye on Centene's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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).
While Centene's low debt to EBITDA ratio of 0.84 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.0 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Unfortunately, Centene saw its EBIT slide 9.2% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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 Centene'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Centene produced sturdy free cash flow equating to 64% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Centene's net debt to EBITDA was a real positive on this analysis, as was its conversion of EBIT to free cash flow. On the other hand, its EBIT growth rate makes us a little less comfortable about its debt. We would also note that Healthcare industry companies like Centene commonly do use debt without problems. Looking at all this data makes us feel a little cautious about Centene's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. To that end, you should be aware of the 4 warning signs we've spotted with Centene .
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.
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