Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. 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. We note that Insulet Corporation (NASDAQ:PODD) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Insulet's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Insulet had debt of US$607.4m, up from US$577.1m in one year. On the flip side, it has US$309.7m in cash leading to net debt of about US$297.6m.
How Strong Is Insulet's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Insulet had liabilities of US$105.8m due within 12 months and liabilities of US$622.2m due beyond that. Offsetting these obligations, it had cash of US$309.7m as well as receivables valued at US$78.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$339.5m.
Given Insulet has a market capitalization of US$9.61b, 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.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Insulet's debt to EBITDA ratio (4.2) suggests that it uses some debt, its interest cover is very weak, at 2.4, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. The silver lining is that Insulet grew its EBIT by 802% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Insulet 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last two years, Insulet saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Insulet's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better In particular, we are dazzled with its EBIT growth rate. It's also worth noting that Insulet is in the Medical Equipment industry, which is often considered to be quite defensive. When we consider all the factors mentioned above, we do feel a bit cautious about Insulet's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Insulet insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.