Here's Why Estia Health (ASX:EHE) Has A Meaningful Debt Burden
Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We note that Estia Health Limited (ASX:EHE) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. 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 think about a company's use of debt, we first look at cash and debt together.
See our latest analysis for Estia Health
What Is Estia Health's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Estia Health had AU$126.3m of debt, an increase on AU$76.4m, over one year. However, it does have AU$14.6m in cash offsetting this, leading to net debt of about AU$111.7m.
A Look At Estia Health's Liabilities
Zooming in on the latest balance sheet data, we can see that Estia Health had liabilities of AU$896.0m due within 12 months and liabilities of AU$237.3m due beyond that. Offsetting these obligations, it had cash of AU$14.6m as well as receivables valued at AU$9.65m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$1.11b.
This deficit casts a shadow over the AU$669.8m 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, Estia Health would probably need a major re-capitalization if its creditors were to demand repayment.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).
Estia Health has a low net debt to EBITDA ratio of only 1.2. And its EBIT easily covers its interest expense, being 13.5 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Estia Health's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Estia Health'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, 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. During the last three years, Estia Health produced sturdy free cash flow equating to 80% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Our View
While Estia Health's level of total liabilities has us nervous. For example, its interest cover and conversion of EBIT to free cash flow give us some confidence in its ability to manage its debt. It's also worth noting that Estia Health is in the Healthcare industry, which is often considered to be quite defensive. Looking at all the angles mentioned above, it does seem to us that Estia Health is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. Given our hesitation about the stock, it would be good to know if Estia Health insiders have sold any shares recently. You click here to find out if insiders have sold recently.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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.
