Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 can see that Thermo Fisher Scientific Inc. (NYSE:TMO) does use debt in its business. 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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Thermo Fisher Scientific's Net Debt?
As you can see below, Thermo Fisher Scientific had US$19.1b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. On the flip side, it has US$2.29b in cash leading to net debt of about US$16.8b.
How Strong Is Thermo Fisher Scientific's Balance Sheet?
We can see from the most recent balance sheet that Thermo Fisher Scientific had liabilities of US$7.51b falling due within a year, and liabilities of US$21.7b due beyond that. Offsetting these obligations, it had cash of US$2.29b as well as receivables valued at US$4.78b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$22.2b.
Thermo Fisher Scientific has a very large market capitalization of US$108.5b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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).
With net debt to EBITDA of 2.7 Thermo Fisher Scientific has a fairly noticeable amount of debt. On the plus side, its EBIT was 8.7 times its interest expense, and its net debt to EBITDA, was quite high, at 2.7. If Thermo Fisher Scientific can keep growing EBIT at last year's rate of 15% over the last year, then it will find its debt load easier to manage. 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 Thermo Fisher Scientific can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Thermo Fisher Scientific recorded free cash flow worth a fulsome 100% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
Happily, Thermo Fisher Scientific's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its net debt to EBITDA. When we consider the range of factors above, it looks like Thermo Fisher Scientific is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. We'd be motivated to research the stock further if we found out that Thermo Fisher Scientific insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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