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.’ 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 Jazz Pharmaceuticals plc (NASDAQ:JAZZ) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Jazz Pharmaceuticals’s Debt?
The image below, which you can click on for greater detail, shows that at June 2020 Jazz Pharmaceuticals had debt of US$2.11b, up from US$1.60b in one year. However, it also had US$1.70b in cash, and so its net debt is US$412.5m.
How Strong Is Jazz Pharmaceuticals’s Balance Sheet?
According to the last reported balance sheet, Jazz Pharmaceuticals had liabilities of US$410.0m due within 12 months, and liabilities of US$2.51b due beyond 12 months. Offsetting this, it had US$1.70b in cash and US$351.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$876.7m.
Given Jazz Pharmaceuticals has a market capitalization of US$6.99b, it’s hard to believe these liabilities pose much threat. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With net debt sitting at just 0.42 times EBITDA, Jazz Pharmaceuticals is arguably pretty conservatively geared. And it boasts interest cover of 8.5 times, which is more than adequate. But the bad news is that Jazz Pharmaceuticals has seen its EBIT plunge 16% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Jazz Pharmaceuticals 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Jazz Pharmaceuticals generated free cash flow amounting to a very robust 81% of its EBIT, more than we’d expect. That positions it well to pay down debt if desirable to do so.
The good news is that Jazz Pharmaceuticals’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its EBIT growth rate. All these things considered, it appears that Jazz Pharmaceuticals can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we’ve discovered 3 warning signs for Jazz Pharmaceuticals that you should be aware of before investing here.
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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