Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Pine Care Group Limited (HKG:1989) does carry 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.
How Much Debt Does Pine Care Group Carry?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Pine Care Group had HK$593.5m of debt, an increase on HK$531.6m, over one year. However, it also had HK$50.9m in cash, and so its net debt is HK$542.6m.
How Strong Is Pine Care Group's Balance Sheet?
We can see from the most recent balance sheet that Pine Care Group had liabilities of HK$76.1m falling due within a year, and liabilities of HK$561.6m due beyond that. Offsetting this, it had HK$50.9m in cash and HK$2.35m in receivables that were due within 12 months. So its liabilities total HK$584.4m more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's market capitalization of HK$541.7m, we think shareholders really should watch Pine Care Group'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 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.
While Pine Care Group's debt to EBITDA ratio of 16.7 suggests a heavy debt load, its interest coverage of 7.3 implies it services that debt with ease. Our best guess is that the company does indeed have significant debt obligations. One way Pine Care Group could vanquish its debt would be if it stops borrowing more but conitinues to grow EBIT at around 10%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Pine Care Group will need earnings to service that debt. 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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Pine Care Group burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
On the face of it, Pine Care Group's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. It's also worth noting that Pine Care Group is in the Healthcare industry, which is often considered to be quite defensive. Overall, we think it's fair to say that Pine Care Group has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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.
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