The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Cantel Medical Corp. (NYSE:CMD) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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 Cantel Medical's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of July 2019 Cantel Medical had US$220.9m of debt, an increase on US$197.3m, over one year. However, it does have US$44.5m in cash offsetting this, leading to net debt of about US$176.3m.
A Look At Cantel Medical's Liabilities
The latest balance sheet data shows that Cantel Medical had liabilities of US$151.4m due within a year, and liabilities of US$257.4m falling due after that. On the other hand, it had cash of US$44.5m and US$148.1m worth of receivables due within a year. So it has liabilities totalling US$216.2m more than its cash and near-term receivables, combined.
Given Cantel Medical has a market capitalization of US$3.28b, 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 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With net debt sitting at just 1.4 times EBITDA, Cantel Medical is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 8.8 times the interest expense over the last year. The modesty of its debt load may become crucial for Cantel Medical if management cannot prevent a repeat of the 36% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Cantel Medical 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Cantel Medical recorded free cash flow of 43% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Cantel Medical's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better There's no doubt that it has an adequate capacity to cover its interest expense with its EBIT. It's also worth noting that Cantel Medical is in the Medical Equipment industry, which is often considered to be quite defensive. Looking at all this data makes us feel a little cautious about Cantel Medical's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Cantel Medical 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 firstname.lastname@example.org. 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.