The U.S. health care industry was a larger part of the U.S. equity markets entering 2016 than at any other point in the prior decade. Consider that health care stocks listed on the S&P 500 accounted for 15.20% of the index's total market capitalization on Dec. 31, 2015. This is approximately 1.5 times larger than the 10.90% it made up on Dec. 31, 2010, and still much larger than the 12.14% figure from the end of 2006.

Thanks to cheap financing and a new urge to expand under the Affordable Care Act (ACA), health care saw high levels of merger and acquisition (M&A) activity between 2010 and 2015. Larger companies often issued bonds to raise money and take over target competitors. Thanks to ultra-low interest rates and encouragement to borrow from the federal government, health care providers rarely found it difficult to raise money or refinance existing debts. The result has been an increasingly levered up, extended industry.

The Role of Debt in the Health Care Sector

As in almost any industry, large health care firms issue debt and borrow money to expand without diluting ownership. Large pharmaceutical or medical device companies partner with big banks and other financial professionals when they want to build new facilities, research and distribute new products, or to buy out another firm.

Debt collection and debt payments are both significant in the health care sector. Providers tend to have huge receivables on their balance sheet, meaning firms must be efficient at collections to pay for their own loans. This is not always easy, since the payment process in health care is complicated compared to most industries.

The average health care customer does not directly pay for most, if any, of his medical bills. Instead, customers are removed from costs, and an insurance company receives the bill. Even here, it is often not the customers, but their employers who pick medical coverage and pay for insurance costs. This is because it is more tax efficient for most companies to pay for health care than to pay out an equivalent amount in extra wages. The ACA required large employers to cover health care, placing several degrees of separation between the economic event and its payment.

Health Care Debt Levels, 2006 to 2015

The case can be made that health care companies entered 2016 with more debt-loaded balance sheets than ever before. Among S&P 500-listed providers, the average debt-to-asset ratio was 21.57% in 2006. This crept up a little bit until 2008, when it sat at 22.22%. After the credit crunch that accompanied the Great Recession, the health care sector reached a period low of 20.87%. The average debt-to-asset ratio moved back up to 22.75% by 2010, 26.85% by 2012 and 28.13% by 2014. Then the average ratio jumped to 31.45% during 2015. To put these figures in perspective, the average debt-to-asset ratio jumped approximately 50% between 2009 and 2015. Keep in mind that this is only among S&P 500-listed companies: the blue chips. Cautious smaller firms, knowing they are less able to assume more debt risk, likely fell behind as bigger and more ambitious firms expanded. Aggressive smaller firms likely put their balance sheets in precarious positions to take advantage of cheap financing.

Taking another measurement, the U.S. health care sector reached a new high in its leverage ratio during Q4 2015. The leverage ratio, a favorite of fundamental analysts, compares total liabilities to stockholder equity, indicating how much in liabilities are owed for $1 of equity. Higher leverage ratios indicate weaker balance sheets. During Q4 2015, the health care sector's leverage ratio was 2.54, meaning greater than 2.5 times as many liabilities as stockholder equity. By comparison, this figure was just 0.80 in Q1 2006. Relative to shareholder equity, health care companies took on more than 300% in liabilities in just over 10 years.

What It Means

Thanks to the ACA, which mandates health insurance and even further removes competitive pricing from the markets, large health care companies do not have to worry about an elastic demand curve for their products or services. Even if valuations fall and balance sheets are increasingly compromised, the economy may very well see rising health care costs and stubborn providers. The biggest concern might be with health care accounts receivable management, since if companies fall behind on collections, it will not matter how high they mark up their services. Then again, it is possible that acquiring firms will boost cash flow and pay down debts. Fitch suggested as much in January 2016, though it ultimately predicted extra cash will instead be used for share repurchases and additional acquisitions.

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