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Is Sonic Healthcare (ASX:SHL) Using Too Much Debt?

Simply Wall St

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Sonic Healthcare Limited (ASX:SHL) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. 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.

See our latest analysis for Sonic Healthcare

How Much Debt Does Sonic Healthcare Carry?

As you can see below, at the end of June 2019, Sonic Healthcare had AU$3.03b of debt, up from AU$2.80b a year ago. Click the image for more detail. On the flip side, it has AU$736.6m in cash leading to net debt of about AU$2.30b.

ASX:SHL Historical Debt, September 20th 2019

How Strong Is Sonic Healthcare's Balance Sheet?

We can see from the most recent balance sheet that Sonic Healthcare had liabilities of AU$1.85b falling due within a year, and liabilities of AU$2.62b due beyond that. On the other hand, it had cash of AU$736.6m and AU$827.9m worth of receivables due within a year. So its liabilities total AU$2.90b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Sonic Healthcare has a market capitalization of AU$13.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Sonic Healthcare's net debt of 2.2 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 8.8 times interest expense) certainly does not do anything to dispel this impression. Sonic Healthcare grew its EBIT by 8.6% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Sonic Healthcare can strengthen its balance sheet over time. 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Sonic Healthcare recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Sonic Healthcare'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 we also thought its conversion of EBIT to free cash flow was a positive. We would also note that Healthcare industry companies like Sonic Healthcare commonly do use debt without problems. All these things considered, it appears that Sonic Healthcare can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Sonic Healthcare insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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.