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. 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 Paragon Care Limited (ASX:PGC) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
You can click the graphic below for the historical numbers, but it shows that Paragon Care had AU$97.7m of debt in June 2019, down from AU$104.8m, one year before. However, because it has a cash reserve of AU$34.2m, its net debt is less, at about AU$63.4m.
ASX:PGC Historical Debt, November 4th 2019
How Strong Is Paragon Care's Balance Sheet?
The latest balance sheet data shows that Paragon Care had liabilities of AU$72.9m due within a year, and liabilities of AU$119.0m falling due after that. Offsetting this, it had AU$34.2m in cash and AU$49.9m in receivables that were due within 12 months. So it has liabilities totalling AU$107.8m more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of AU$148.7m. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Paragon Care has a debt to EBITDA ratio of 3.0 and its EBIT covered its interest expense 3.1 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. The good news is that Paragon Care improved its EBIT by 8.9% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. 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 Paragon Care'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.
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. Over the last three years, Paragon Care recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
Our View
On the face of it, Paragon Care's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. It's also worth noting that Paragon Care is in the Healthcare industry, which is often considered to be quite defensive. Once we consider all the factors above, together, it seems to us that Paragon Care's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. Given our hesitation about the stock, it would be good to know if Paragon Care insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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.
