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. 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. Importantly, Healthcare Services Group, Inc. (NASDAQ:HCSG) does carry debt. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.
What Is Healthcare Services Group's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Healthcare Services Group had US$30.0m of debt in June 2019, down from US$40.5m, one year before. However, it does have US$95.7m in cash offsetting this, leading to net cash of US$65.7m.
A Look At Healthcare Services Group's Liabilities
According to the last reported balance sheet, Healthcare Services Group had liabilities of US$151.4m due within 12 months, and liabilities of US$109.1m due beyond 12 months. Offsetting this, it had US$95.7m in cash and US$346.8m in receivables that were due within 12 months. So it can boast US$182.0m more liquid assets than total liabilities.
This short term liquidity is a sign that Healthcare Services Group could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Healthcare Services Group has more cash than debt is arguably a good indication that it can manage its debt safely.
Fortunately, Healthcare Services Group grew its EBIT by 9.0% in the last year, making that debt load look even more manageable. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Healthcare Services Group 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Healthcare Services Group may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Healthcare Services Group's free cash flow amounted to 36% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
While we empathize with investors who find debt concerning, you should keep in mind that Healthcare Services Group has net cash of US$65.7m, as well as more liquid assets than liabilities. And it also grew its EBIT by 9.0% over the last year. So is Healthcare Services Group's debt a risk? It doesn't seem so to us. We'd be motivated to research the stock further if we found out that Healthcare Services Group insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.