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 note that Abbott Laboratories (NYSE:ABT) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Abbott Laboratories's Debt?
As you can see below, Abbott Laboratories had US$19.1b of debt at September 2019, down from US$23.8b a year prior. However, it also had US$4.34b in cash, and so its net debt is US$14.8b.
How Strong Is Abbott Laboratories's Balance Sheet?
The latest balance sheet data shows that Abbott Laboratories had liabilities of US$10.5b due within a year, and liabilities of US$26.0b falling due after that. Offsetting this, it had US$4.34b in cash and US$5.45b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$26.7b.
Given Abbott Laboratories has a humongous market capitalization of US$145.6b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
Abbott Laboratories's net debt of 1.9 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 8.0 times interest expense) certainly does not do anything to dispel this impression. Also relevant is that Abbott Laboratories has grown its EBIT by a very respectable 29% in the last year, thus enhancing its ability to pay down debt. 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 Abbott Laboratories 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Abbott Laboratories 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.
The good news is that Abbott Laboratories's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its EBIT growth rate also supports that impression! We would also note that Medical Equipment industry companies like Abbott Laboratories commonly do use debt without problems. Zooming out, Abbott Laboratories seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. Another factor that would give us confidence in Abbott Laboratories 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.
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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