Does Select Medical Holdings (NYSE:SEM) Have A Healthy Balance Sheet?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Select Medical Holdings Corporation (NYSE:SEM) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Select Medical Holdings

How Much Debt Does Select Medical Holdings Carry?

As you can see below, Select Medical Holdings had US$3.85b of debt, at March 2024, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$135.3m in cash, and so its net debt is US$3.71b.

How Strong Is Select Medical Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Select Medical Holdings had liabilities of US$1.18b due within 12 months and liabilities of US$5.01b due beyond that. Offsetting this, it had US$135.3m in cash and US$1.13b in receivables that were due within 12 months. So it has liabilities totalling US$4.92b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's US$4.31b market capitalization, you might well be inclined to review the balance sheet intently. 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.

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.

Select Medical Holdings has a debt to EBITDA ratio of 4.6 and its EBIT covered its interest expense 3.0 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Looking on the bright side, Select Medical Holdings boosted its EBIT by a silky 40% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. 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 Select Medical Holdings'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. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Select Medical Holdings's free cash flow amounted to 23% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Neither Select Medical Holdings's ability handle its debt, based on its EBITDA, nor its level of total liabilities gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. We should also note that Healthcare industry companies like Select Medical Holdings commonly do use debt without problems. When we consider all the factors discussed, it seems to us that Select Medical Holdings is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example Select Medical Holdings has 2 warning signs (and 1 which is a bit concerning) we think you should know about.

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.