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 PW Medtech Group Limited (HKG:1358) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is PW Medtech Group's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 PW Medtech Group had CN¥577.6m of debt, an increase on none, over one year. However, it also had CN¥88.1m in cash, and so its net debt is CN¥489.5m.
How Strong Is PW Medtech Group's Balance Sheet?
We can see from the most recent balance sheet that PW Medtech Group had liabilities of CN¥691.2m falling due within a year, and liabilities of CN¥8.20m due beyond that. Offsetting this, it had CN¥88.1m in cash and CN¥252.3m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥359.0m.
This deficit isn't so bad because PW Medtech Group is worth CN¥1.76b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
Weak interest cover of 2.0 times and a disturbingly high net debt to EBITDA ratio of 7.2 hit our confidence in PW Medtech Group like a one-two punch to the gut. The debt burden here is substantial. More concerning, PW Medtech Group saw its EBIT drop by 8.7% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if PW Medtech 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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, PW Medtech Group burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both PW Medtech Group's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability to handle its total liabilities isn't such a worry. We should also note that Medical Equipment industry companies like PW Medtech Group commonly do use debt without problems. Overall, we think it's fair to say that PW Medtech Group has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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