David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that AdaptHealth Corp. (NASDAQ:AHCO) 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does AdaptHealth Carry?
As you can see below, AdaptHealth had US$2.15b of debt, at December 2023, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$81.6m, its net debt is less, at about US$2.07b.
How Healthy Is AdaptHealth's Balance Sheet?
According to the last reported balance sheet, AdaptHealth had liabilities of US$537.0m due within 12 months, and liabilities of US$2.50b due beyond 12 months. Offsetting these obligations, it had cash of US$81.6m as well as receivables valued at US$421.1m due within 12 months. So its liabilities total US$2.54b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the US$1.35b 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, AdaptHealth 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).
While AdaptHealth's debt to EBITDA ratio (3.2) suggests that it uses some debt, its interest cover is very weak, at 2.0, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. On the other hand, AdaptHealth grew its EBIT by 28% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if AdaptHealth can strengthen its balance sheet over time. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, AdaptHealth recorded free cash flow of 29% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
To be frank both AdaptHealth's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. It's also worth noting that AdaptHealth is in the Healthcare industry, which is often considered to be quite defensive. Looking at the bigger picture, it seems clear to us that AdaptHealth's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with AdaptHealth , and understanding them should be part of your investment process.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.