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. We note that Varian Medical Systems, Inc. (NYSE:VAR) does have debt on its balance sheet. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.
What Is Varian Medical Systems's Debt?
The image below, which you can click on for greater detail, shows that at April 2020 Varian Medical Systems had debt of US$520.0m, up from none in one year. However, its balance sheet shows it holds US$667.8m in cash, so it actually has US$147.8m net cash.
How Strong Is Varian Medical Systems's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Varian Medical Systems had liabilities of US$1.95b due within 12 months and liabilities of US$523.5m due beyond that. Offsetting this, it had US$667.8m in cash and US$1.01b in receivables that were due within 12 months. So it has liabilities totalling US$790.6m more than its cash and near-term receivables, combined.
Of course, Varian Medical Systems has a titanic market capitalization of US$11.5b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Varian Medical Systems also has more cash than debt, so we're pretty confident it can manage its debt safely.
While Varian Medical Systems doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Varian Medical Systems'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Varian Medical Systems may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Varian Medical Systems recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Varian Medical Systems has US$147.8m in net cash. The cherry on top was that in converted 75% of that EBIT to free cash flow, bringing in US$309m. So we don't think Varian Medical Systems's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Varian Medical Systems you should be aware of.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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