Does Advanced Health (JSE:AVL) Have A Healthy Balance Sheet?

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.' 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. As with many other companies Advanced Health Limited (JSE:AVL) makes use of debt. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Advanced Health

What Is Advanced Health's Debt?

The image below, which you can click on for greater detail, shows that Advanced Health had debt of R194.1m at the end of December 2020, a reduction from R231.3m over a year. However, it does have R70.7m in cash offsetting this, leading to net debt of about R123.4m.

How Healthy Is Advanced Health's Balance Sheet?

According to the last reported balance sheet, Advanced Health had liabilities of R332.5m due within 12 months, and liabilities of R594.3m due beyond 12 months. Offsetting this, it had R70.7m in cash and R34.3m in receivables that were due within 12 months. So its liabilities total R821.9m more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the R209.5m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Advanced Health would probably need a major re-capitalization if its creditors were to demand repayment.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Given net debt is only 1.2 times EBITDA, it is initially surprising to see that Advanced Health's EBIT has low interest coverage of 0.18 times. So one way or the other, it's clear the debt levels are not trivial. Pleasingly, Advanced Health is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 796% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Advanced Health's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last two years, Advanced Health actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

While Advanced Health's level of total liabilities has us nervous. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. It's also worth noting that Advanced Health is in the Healthcare industry, which is often considered to be quite defensive. We think that Advanced Health's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for Advanced Health (2 are significant) you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. 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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