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.’ 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. Importantly, Tenet Healthcare Corporation (NYSE:THC) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. 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. When we think about a company’s use of debt, we first look at cash and debt together.
View our latest analysis for Tenet Healthcare
What Is Tenet Healthcare’s Debt?
As you can see below, at the end of September 2022, Tenet Healthcare had US$14.6b of debt, up from US$13.8b a year ago. Click the image for more detail. However, it also had US$1.21b in cash, and so its net debt is US$13.4b.
How Strong Is Tenet Healthcare’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Tenet Healthcare had liabilities of US$4.28b due within 12 months and liabilities of US$18.2b due beyond that. Offsetting these obligations, it had cash of US$1.21b as well as receivables valued at US$3.77b due within 12 months. So its liabilities total US$17.5b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the US$5.70b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Tenet Healthcare would likely require a major re-capitalisation if it had to pay its creditors today.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).
Tenet Healthcare’s debt is 4.0 times its EBITDA, and its EBIT cover its interest expense 2.8 times over. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Given the debt load, it’s hardly ideal that Tenet Healthcare’s EBIT was pretty flat over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Tenet Healthcare’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.
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, Tenet Healthcare produced sturdy free cash flow equating to 66% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Mulling over Tenet Healthcare’s attempt at staying on top of its total liabilities, we’re certainly not enthusiastic. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. It’s also worth noting that Tenet Healthcare is in the Healthcare industry, which is often considered to be quite defensive. Looking at the bigger picture, it seems clear to us that Tenet Healthcare’s use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We’ve identified 3 warning signs with Tenet Healthcare (at least 1 which is concerning) , and understanding them should be part of your investment process.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
What are the risks and opportunities for Tenet Healthcare?
Tenet Healthcare Corporation operates as a diversified healthcare services company.
Trading at 23.2% below our estimate of its fair value
Earnings are forecast to grow 15.44% per year
Interest payments are not well covered by earnings
Significant insider selling over the past 3 months
Profit margins (2.9%) are lower than last year (5.5%)
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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.