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. As with many other companies Smith & Nephew plc (LON:SN.) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Smith & Nephew Carry?
As you can see below, at the end of June 2019, Smith & Nephew had US$2.02b of debt, up from US$1.51b a year ago. Click the image for more detail. On the flip side, it has US$137.0m in cash leading to net debt of about US$1.88b.
A Look At Smith & Nephew's Liabilities
According to the last reported balance sheet, Smith & Nephew had liabilities of US$1.47b due within 12 months, and liabilities of US$2.52b due beyond 12 months. Offsetting these obligations, it had cash of US$137.0m as well as receivables valued at US$1.28b due within 12 months. So its liabilities total US$2.58b more than the combination of its cash and short-term receivables.
Given Smith & Nephew has a humongous market capitalization of US$20.3b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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).
Smith & Nephew's net debt is only 1.3 times its EBITDA. And its EBIT covers its interest expense a whopping 19.9 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also positive, Smith & Nephew grew its EBIT by 20% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Smith & Nephew 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 we always check how much of that EBIT is translated into free cash flow. During the last three years, Smith & Nephew produced sturdy free cash flow equating to 70% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Smith & Nephew's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. We would also note that Medical Equipment industry companies like Smith & Nephew commonly do use debt without problems. Looking at the bigger picture, we think Smith & Nephew's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. Another factor that would give us confidence in Smith & Nephew would be if insiders have been buying shares: if you're conscious of that signal too, you can find out instantly by clicking this link.
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.
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