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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Stryker Corporation (NYSE:SYK) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Stryker's Net Debt?
As you can see below, at the end of June 2019, Stryker had US$8.51b of debt, up from US$7.20b a year ago. Click the image for more detail. However, because it has a cash reserve of US$1.84b, its net debt is less, at about US$6.67b.
A Look At Stryker's Liabilities
The latest balance sheet data shows that Stryker had liabilities of US$3.95b due within a year, and liabilities of US$10.5b falling due after that. On the other hand, it had cash of US$1.84b and US$2.41b worth of receivables due within a year. So it has liabilities totalling US$10.2b more than its cash and near-term receivables, combined.
Since publicly traded Stryker shares are worth a very impressive total of US$82.6b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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.
Stryker's net debt to EBITDA ratio of about 1.7 suggests only moderate use of debt. And its strong interest cover of 26.7 times, makes us even more comfortable. One way Stryker could vanquish its debt would be if it stops borrowing more but conitinues to grow EBIT at around 12%, 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 Stryker's ability to maintain a healthy balance sheet going forward. 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 we always check how much of that EBIT is translated into free cash flow. During the last three years, Stryker produced sturdy free cash flow equating to 50% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
The good news is that Stryker's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And its EBIT growth rate is good too. It's also worth noting that Stryker is in the Medical Equipment industry, which is often considered to be quite defensive. When we consider the range of factors above, it looks like Stryker is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. We'd be motivated to research the stock further if we found out that Stryker 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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