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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Acadia Healthcare Company, Inc. (NASDAQ:ACHC) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Acadia Healthcare Company's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Acadia Healthcare Company had US$1.86b of debt, an increase on US$1.42b, over one year. However, because it has a cash reserve of US$77.3m, its net debt is less, at about US$1.78b.

A Look At Acadia Healthcare Company's Liabilities

We can see from the most recent balance sheet that Acadia Healthcare Company had liabilities of US$482.3m falling due within a year, and liabilities of US$2.06b due beyond that. Offsetting these obligations, it had cash of US$77.3m as well as receivables valued at US$471.1m due within 12 months. So its liabilities total US$1.99b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Acadia Healthcare Company is worth US$6.15b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Acadia Healthcare Company has a debt to EBITDA ratio of 2.7 and its EBIT covered its interest expense 5.9 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. One way Acadia Healthcare Company could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 14%, as it did over the last year. 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 Acadia Healthcare Company'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Acadia Healthcare Company 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 an improvement.

Our View

Acadia Healthcare Company's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its EBIT growth rate is relatively strong. We should also note that Healthcare industry companies like Acadia Healthcare Company commonly do use debt without problems. Looking at all the angles mentioned above, it does seem to us that Acadia Healthcare Company is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Acadia Healthcare Company you should know about.

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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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com