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. Importantly, PRA Health Sciences, Inc. (NASDAQ:PRAH) does carry debt. But the real question is whether this debt is making the company risky.
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is PRA Health Sciences's Debt?
You can click the graphic below for the historical numbers, but it shows that PRA Health Sciences had US$1.12b of debt in June 2019, down from US$1.30b, one year before. On the flip side, it has US$141.9m in cash leading to net debt of about US$974.6m.
A Look At PRA Health Sciences's Liabilities
We can see from the most recent balance sheet that PRA Health Sciences had liabilities of US$879.8m falling due within a year, and liabilities of US$1.40b due beyond that. Offsetting these obligations, it had cash of US$141.9m as well as receivables valued at US$637.5m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.50b.
PRA Health Sciences has a market capitalization of US$6.39b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With a debt to EBITDA ratio of 2.1, PRA Health Sciences uses debt artfully but responsibly. And the alluring interest cover (EBIT of 7.5 times interest expense) certainly does not do anything to dispel this impression. We note that PRA Health Sciences grew its EBIT by 25% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine PRA Health Sciences'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, PRA Health Sciences produced sturdy free cash flow equating to 62% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, PRA Health Sciences's impressive EBIT growth rate implies it has the upper hand on its debt. And we also thought its conversion of EBIT to free cash flow was a positive. Taking all this data into account, it seems to us that PRA Health Sciences takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of PRA Health Sciences's earnings per share history 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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