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 seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. As with many other companies Owens & Minor, Inc. (NYSE:OMI) makes use of debt. But the more important question is: how much risk is that debt creating?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.
How Much Debt Does Owens & Minor Carry?
The image below, which you can click on for greater detail, shows that Owens & Minor had debt of US$1.56b at the end of December 2019, a reduction from US$1.68b over a year. However, it also had US$67.0m in cash, and so its net debt is US$1.50b.
A Look At Owens & Minor’s Liabilities
Zooming in on the latest balance sheet data, we can see that Owens & Minor had liabilities of US$1.42b due within 12 months and liabilities of US$1.76b due beyond that. Offsetting this, it had US$67.0m in cash and US$674.7m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.44b.
This deficit casts a shadow over the US$426.7m company, like a colossus towering over mere mortals. So we’d watch its balance sheet closely, without a doubt. After all, Owens & Minor would likely require a major re-capitalisation if it had to pay its creditors today.
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.
Weak interest cover of 1.0 times and a disturbingly high net debt to EBITDA ratio of 8.0 hit our confidence in Owens & Minor like a one-two punch to the gut. The debt burden here is substantial. Another concern for investors might be that Owens & Minor’s EBIT fell 14% in the last year. If that’s the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. 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 Owens & Minor’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. So it’s worth checking how much of that EBIT is backed by free cash flow. In the last three years, Owens & Minor’s free cash flow amounted to 46% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
On the face of it, Owens & Minor’s interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least its conversion of EBIT to free cash flow is not so bad. It’s also worth noting that Owens & Minor is in the Healthcare industry, which is often considered to be quite defensive. Taking into account all the aforementioned factors, it looks like Owens & Minor has too much debt. While some investors love that sort of risky play, it’s certainly not our cup of tea. 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. Take risks, for example – Owens & Minor has 2 warning signs (and 1 which is a bit unpleasant) we think you should know about.
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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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