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Is Quest Diagnostics (NYSE:DGX) A Risky Investment?

Simply Wall St

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, Quest Diagnostics Incorporated (NYSE:DGX) does carry debt. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

View our latest analysis for Quest Diagnostics

What Is Quest Diagnostics's Debt?

The chart below, which you can click on for greater detail, shows that Quest Diagnostics had US$3.98b in debt in June 2019; about the same as the year before. However, it also had US$273.0m in cash, and so its net debt is US$3.71b.

NYSE:DGX Historical Debt, October 16th 2019

How Strong Is Quest Diagnostics's Balance Sheet?

According to the last reported balance sheet, Quest Diagnostics had liabilities of US$1.90b due within 12 months, and liabilities of US$4.27b due beyond 12 months. Offsetting this, it had US$273.0m in cash and US$1.09b in receivables that were due within 12 months. So its liabilities total US$4.81b more than the combination of its cash and short-term receivables.

Quest Diagnostics has a very large market capitalization of US$14.1b, 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.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Quest Diagnostics's debt is 2.5 times its EBITDA, and its EBIT cover its interest expense 6.7 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Unfortunately, Quest Diagnostics's EBIT flopped 10% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Quest Diagnostics 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 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. During the last three years, Quest Diagnostics produced sturdy free cash flow equating to 70% 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.

Our View

On our analysis Quest Diagnostics's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to grow its EBIT. It's also worth noting that Quest Diagnostics is in the Healthcare industry, which is often considered to be quite defensive. When we consider all the factors mentioned above, we do feel a bit cautious about Quest Diagnostics's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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 Quest Diagnostics's earnings per share history for free.

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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.