Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. Importantly, Johnson & Johnson (NYSE:JNJ) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Johnson & Johnson Carry?
The image below, which you can click on for greater detail, shows that Johnson & Johnson had debt of US$29.4b at the end of June 2019, a reduction from US$31.3b over a year. On the flip side, it has US$15.3b in cash leading to net debt of about US$14.1b.
How Healthy Is Johnson & Johnson's Balance Sheet?
The latest balance sheet data shows that Johnson & Johnson had liabilities of US$31.4b due within a year, and liabilities of US$63.0b falling due after that. Offsetting these obligations, it had cash of US$15.3b as well as receivables valued at US$14.7b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$64.4b.
Of course, Johnson & Johnson has a titanic market capitalization of US$341.0b, so these liabilities are probably manageable. 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).
Johnson & Johnson has a low net debt to EBITDA ratio of only 0.51. And its EBIT easily covers its interest expense, being 2k times the size. So we're pretty relaxed about its super-conservative use of debt. While Johnson & Johnson doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Johnson & Johnson's ability to maintain a healthy balance sheet going forward. 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. During the last three years, Johnson & Johnson generated free cash flow amounting to a very robust 89% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Johnson & Johnson'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 the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Zooming out, Johnson & Johnson 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. We'd be motivated to research the stock further if we found out that Johnson & Johnson 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.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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