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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, UDG Healthcare plc (LON:UDG) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. 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 examine debt levels, we first consider both cash and debt levels, together.
What Is UDG Healthcare's Net Debt?
You can click the graphic below for the historical numbers, but it shows that UDG Healthcare had US$240.7m of debt in March 2019, down from US$257.5m, one year before. However, it also had US$171.9m in cash, and so its net debt is US$68.8m.
A Look At UDG Healthcare's Liabilities
We can see from the most recent balance sheet that UDG Healthcare had liabilities of US$297.6m falling due within a year, and liabilities of US$350.1m due beyond that. Offsetting these obligations, it had cash of US$171.9m as well as receivables valued at US$379.6m due within 12 months. So its liabilities total US$96.2m more than the combination of its cash and short-term receivables.
Of course, UDG Healthcare has a market capitalization of US$2.41b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
UDG Healthcare has a low net debt to EBITDA ratio of only 0.41. And its EBIT covers its interest expense a whopping 16.0 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The good news is that UDG Healthcare has increased its EBIT by 3.4% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine UDG Healthcare'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, UDG Healthcare produced sturdy free cash flow equating to 53% 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, UDG Healthcare's impressive interest cover implies it has the upper hand on its debt. And its net debt to EBITDA is good too. We would also note that Healthcare industry companies like UDG Healthcare commonly do use debt without problems. Taking all this data into account, it seems to us that UDG Healthcare takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that UDG 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.
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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