Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk’. 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, ResMed Inc. (NYSE:RMD) does carry debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we think about a company’s use of debt, we first look at cash and debt together.
What Is ResMed’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2019 ResMed had US$1.30b of debt, an increase on US$1.20b, over one year. However, it does have US$204.1m in cash offsetting this, leading to net debt of about US$1.10b.
How Strong Is ResMed’s Balance Sheet?
We can see from the most recent balance sheet that ResMed had liabilities of US$500.0m falling due within a year, and liabilities of US$1.60b due beyond that. Offsetting these obligations, it had cash of US$204.1m as well as receivables valued at US$535.8m due within 12 months. So it has liabilities totalling US$1.36b more than its cash and near-term receivables, combined.
Of course, ResMed has a titanic market capitalization of US$22.4b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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.
ResMed’s net debt is only 1.3 times its EBITDA. And its EBIT easily covers its interest expense, being 15.5 times the size. So we’re pretty relaxed about its super-conservative use of debt. And we also note warmly that ResMed grew its EBIT by 14% last year, making its debt load easier to handle. 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 ResMed 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, ResMed recorded free cash flow worth 64% 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.
Happily, ResMed’s impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! We would also note that Medical Equipment industry companies like ResMed commonly do use debt without problems. Zooming out, ResMed seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. For example, we’ve discovered 2 warning signs for ResMed that you should be aware of before investing here.
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.
If you spot an error that warrants correction, please contact the editor at email@example.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.
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