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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.’ 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. ResMed Inc. (NYSE:RMD) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. 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. 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 ResMed’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 ResMed had US$1.34b of debt, an increase on US$810.0m, over one year. However, it does have US$146.5m in cash offsetting this, leading to net debt of about US$1.19b.
A Look At ResMed’s Liabilities
The latest balance sheet data shows that ResMed had liabilities of US$463.0m due within a year, and liabilities of US$1.61b falling due after that. Offsetting these obligations, it had cash of US$146.5m as well as receivables valued at US$521.8m due within 12 months. So its liabilities total US$1.41b more than the combination of its cash and short-term receivables.
Of course, ResMed has a titanic market capitalization of US$17.7b, 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. Either way, since ResMed does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
ResMed’s net debt to EBITDA ratio of about 1.57 suggests only moderate use of debt. And its strong interest cover of 25.4 times, makes us even more comfortable. If ResMed can keep growing EBIT at last year’s rate of 16% over the last year, then it will find its debt load easier to manage. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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 72% 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.
The good news is that ResMed’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. 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. Looking at the bigger picture, we think ResMed’s use of debt seems quite reasonable and we’re not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. Another factor that would give us confidence in ResMed would be if insiders have been buying shares: if you’re conscious of that signal too, you can find out instantly by clicking this link.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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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. Thank you for reading.