Is Encompass Health (NYSE:EHC) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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, Encompass Health Corporation (NYSE:EHC) does carry debt. But the real question is whether this debt is making the company risky.

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Encompass Health

What Is Encompass Health's Net Debt?

The image below, which you can click on for greater detail, shows that Encompass Health had debt of US$2.37b at the end of June 2023, a reduction from US$2.91b over a year. However, it also had US$117.5m in cash, and so its net debt is US$2.25b.

A Look At Encompass Health's Liabilities

We can see from the most recent balance sheet that Encompass Health had liabilities of US$655.0m falling due within a year, and liabilities of US$3.15b due beyond that. Offsetting these obligations, it had cash of US$117.5m as well as receivables valued at US$532.3m due within 12 months. So its liabilities total US$3.15b more than the combination of its cash and short-term receivables.

Encompass Health has a market capitalization of US$6.57b, 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.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Encompass Health has net debt worth 2.4 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 4.7 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. One way Encompass Health could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 11%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Encompass Health 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Encompass Health's free cash flow amounted to 36% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

When it comes to the balance sheet, the standout positive for Encompass Health was the fact that it seems able to grow its EBIT confidently. But the other factors we noted above weren't so encouraging. For example, its level of total liabilities makes us a little nervous about its debt. We would also note that Healthcare industry companies like Encompass Health commonly do use debt without problems. When we consider all the factors mentioned above, we do feel a bit cautious about Encompass Health's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. For instance, we've identified 2 warning signs for Encompass Health that 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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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.