We Think Encompass Health (NYSE:EHC) Can Stay On Top Of Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Encompass Health Corporation (NYSE:EHC) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Encompass Health

What Is Encompass Health's Net Debt?

The chart below, which you can click on for greater detail, shows that Encompass Health had US$2.37b in debt in September 2023; about the same as the year before. On the flip side, it has US$99.7m in cash leading to net debt of about US$2.27b.

How Healthy Is Encompass Health's Balance Sheet?

The latest balance sheet data shows that Encompass Health had liabilities of US$639.2m due within a year, and liabilities of US$3.14b falling due after that. Offsetting these obligations, it had cash of US$99.7m as well as receivables valued at US$535.9m due within 12 months. So it has liabilities totalling US$3.14b more than its cash and near-term receivables, combined.

Encompass Health has a market capitalization of US$6.82b, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Encompass Health's net debt is sitting at a very reasonable 2.3 times its EBITDA, while its EBIT covered its interest expense just 4.9 times last year. 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 20%, as it did over the last year. 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 Encompass Health'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 always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Encompass Health recorded free cash flow of 35% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

On our analysis Encompass Health's EBIT growth rate should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to convert EBIT to free cash flow. It's also worth noting that Encompass Health is in the Healthcare industry, which is often considered to be quite defensive. Looking at all this data makes us feel a little cautious about Encompass Health'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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Encompass Health , and understanding them should be part of your investment process.

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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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.