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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Select Medical Holdings Corporation (NYSE:SEM) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Select Medical Holdings Carry?

The image below, which you can click on for greater detail, shows that Select Medical Holdings had debt of US$1.73b at the end of December 2024, a reduction from US$3.67b over a year. However, it also had US$59.7m in cash, and so its net debt is US$1.67b.

A Look At Select Medical Holdings' Liabilities

According to the last reported balance sheet, Select Medical Holdings had liabilities of US$977.7m due within 12 months, and liabilities of US$2.63b due beyond 12 months. Offsetting this, it had US$59.7m in cash and US$839.2m in receivables that were due within 12 months. So it has liabilities totalling US$2.71b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's US$2.17b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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

While we wouldn't worry about Select Medical Holdings's net debt to EBITDA ratio of 4.1, we think its super-low interest cover of 2.1 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Given the debt load, it's hardly ideal that Select Medical Holdings's EBIT was pretty flat over the last twelve months. 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 Select Medical Holdings 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Select Medical Holdings actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Select Medical Holdings's interest cover and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. It's also worth noting that Select Medical Holdings is in the Healthcare industry, which is often considered to be quite defensive. When we consider all the factors discussed, it seems to us that Select Medical Holdings is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. For example - Select Medical Holdings has 1 warning sign we think you should be aware of.

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.