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.' 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 Select Medical Holdings Corporation (NYSE:SEM) makes use of debt. But should shareholders be worried about its use of debt?

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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Select Medical Holdings

What Is Select Medical Holdings's Net Debt?

As you can see below, Select Medical Holdings had US$3.66b of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. However, it does have US$133.6m in cash offsetting this, leading to net debt of about US$3.53b.

A Look At Select Medical Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that Select Medical Holdings had liabilities of US$1.26b due within 12 months and liabilities of US$4.88b due beyond that. Offsetting these obligations, it had cash of US$133.6m as well as receivables valued at US$1.08b due within 12 months. So it has liabilities totalling US$4.93b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of US$4.43b, we think shareholders really should watch Select Medical Holdings's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

Select Medical Holdings has a debt to EBITDA ratio of 4.4 and its EBIT covered its interest expense 3.2 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. On the other hand, Select Medical Holdings grew its EBIT by 24% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. When analysing debt levels, the balance sheet is the obvious place to start. 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Select Medical Holdings recorded free cash flow of 32% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither Select Medical Holdings's ability to handle its total liabilities nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. 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. 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. For example, we've discovered 3 warning signs for Select Medical Holdings (1 shouldn't be ignored!) that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.