Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk. So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Wenzhou Kangning Hospital Co., Ltd. (HKG:2120) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is Wenzhou Kangning Hospital's Net Debt?
As you can see below, Wenzhou Kangning Hospital had CN¥249.0m of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, because it has a cash reserve of CN¥95.8m, its net debt is less, at about CN¥153.2m.
A Look At Wenzhou Kangning Hospital's Liabilities
We can see from the most recent balance sheet that Wenzhou Kangning Hospital had liabilities of CN¥492.4m falling due within a year, and liabilities of CN¥258.9m due beyond that. Offsetting these obligations, it had cash of CN¥95.8m as well as receivables valued at CN¥383.8m due within 12 months. So it has liabilities totalling CN¥271.8m more than its cash and near-term receivables, combined.
Of course, Wenzhou Kangning Hospital has a market capitalization of CN¥1.41b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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.
Wenzhou Kangning Hospital has net debt of just 1.2 times EBITDA, suggesting it could ramp leverage without breaking a sweat. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like a hot shot teppanyaki chef handles cooking. In fact Wenzhou Kangning Hospital's saving grace is its low debt levels, because its EBIT has tanked 32% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 Wenzhou Kangning Hospital's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Wenzhou Kangning Hospital burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Wenzhou Kangning Hospital's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. It's also worth noting that Wenzhou Kangning Hospital is in the Healthcare industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think Wenzhou Kangning Hospital's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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