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. 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. We note that Thomson Medical Group Limited (SGX:A50) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 Thomson Medical Group's Debt?
As you can see below, Thomson Medical Group had S$571.6m of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it does have S$127.8m in cash offsetting this, leading to net debt of about S$443.8m.
How Strong Is Thomson Medical Group's Balance Sheet?
According to the last reported balance sheet, Thomson Medical Group had liabilities of S$298.0m due within 12 months, and liabilities of S$360.9m due beyond 12 months. Offsetting these obligations, it had cash of S$127.8m as well as receivables valued at S$23.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by S$507.1m.
While this might seem like a lot, it is not so bad since Thomson Medical Group has a market capitalization of S$1.56b, 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.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Thomson Medical Group shareholders face the double whammy of a high net debt to EBITDA ratio (8.8), and fairly weak interest coverage, since EBIT is just 1.9 times the interest expense. This means we'd consider it to have a heavy debt load. However, one redeeming factor is that Thomson Medical Group grew its EBIT at 19% over the last 12 months, boosting its ability to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Thomson Medical Group's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Thomson Medical Group produced sturdy free cash flow equating to 72% 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.
We weren't impressed with Thomson Medical Group's interest cover, and its net debt to EBITDA made us cautious. But its conversion of EBIT to free cash flow was significantly redeeming. We would also note that Healthcare industry companies like Thomson Medical Group commonly do use debt without problems. When we consider all the elements mentioned above, it seems to us that Thomson Medical Group is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Thomson Medical Group's earnings per share history for free.
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.
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 email@example.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.