David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 note that Merit Medical Systems, Inc. (NASDAQ:MMSI) does have debt on its balance sheet. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 Merit Medical Systems's Net Debt?
The chart below, which you can click on for greater detail, shows that Merit Medical Systems had US$400.2m in debt in June 2019; about the same as the year before. However, it does have US$35.2m in cash offsetting this, leading to net debt of about US$365.0m.
How Healthy Is Merit Medical Systems's Balance Sheet?
The latest balance sheet data shows that Merit Medical Systems had liabilities of US$176.6m due within a year, and liabilities of US$606.7m falling due after that. Offsetting this, it had US$35.2m in cash and US$172.8m in receivables that were due within 12 months. So its liabilities total US$575.2m more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Merit Medical Systems is worth US$2.24b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Merit Medical Systems's net debt of 2.4 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 7.8 times its interest expenses harmonizes with that theme. One way Merit Medical Systems could vanquish its debt would be if it stops borrowing more but conitinues to grow EBIT at around 13%, as it did over the last year. 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 Merit Medical Systems'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Merit Medical Systems recorded free cash flow of 34% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Both Merit Medical Systems's ability to to grow its EBIT and its interest cover gave us comfort that it can handle its debt. Having said that, its conversion of EBIT to free cash flow somewhat sensitizes us to potential future risks to the balance sheet. It's also worth noting that Merit Medical Systems is in the Medical Equipment industry, which is often considered to be quite defensive. Considering this range of data points, we think Merit Medical Systems is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. We'd be motivated to research the stock further if we found out that Merit Medical Systems 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.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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