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.' 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 Handicare Group AB (publ) (STO:HANDI) makes use of debt. But the more important question is: how much risk is that debt creating?
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 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Handicare Group's Net Debt?
The chart below, which you can click on for greater detail, shows that Handicare Group had €104.7m in debt in June 2019; about the same as the year before. On the flip side, it has €29.1m in cash leading to net debt of about €75.6m.
How Strong Is Handicare Group's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Handicare Group had liabilities of €45.0m due within 12 months and liabilities of €138.2m due beyond that. On the other hand, it had cash of €29.1m and €42.3m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €111.8m.
While this might seem like a lot, it is not so bad since Handicare Group has a market capitalization of €201.9m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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).
Handicare Group's debt is 3.1 times its EBITDA, and its EBIT cover its interest expense 4.1 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Even worse, Handicare Group saw its EBIT tank 20% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Handicare Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Handicare Group 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.
Mulling over Handicare Group's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But at least its level of total liabilities is not so bad. It's also worth noting that Handicare Group is in the Medical Equipment industry, which is often considered to be quite defensive. Looking at the bigger picture, it seems clear to us that Handicare Group's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. Over time, share prices tend to follow earnings per share, so if you're interested in Handicare Group, you may well want to click here to check an interactive graph of its earnings per share history.
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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