David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, Jazz Pharmaceuticals plc (NASDAQ:JAZZ) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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 Jazz Pharmaceuticals’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2020 Jazz Pharmaceuticals had US$2.11b of debt, an increase on US$1.60b, over one year. On the flip side, it has US$1.70b in cash leading to net debt of about US$412.5m.
How Strong Is Jazz Pharmaceuticals’s Balance Sheet?
The latest balance sheet data shows that Jazz Pharmaceuticals had liabilities of US$410.0m due within a year, and liabilities of US$2.51b falling due after that. 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. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Jazz Pharmaceuticals has net debt of just 0.42 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 8.5 times, which is more than adequate. On the other hand, Jazz Pharmaceuticals’s EBIT dived 16%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Jazz Pharmaceuticals’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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding 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.
Happily, Jazz Pharmaceuticals’s impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But the stark truth is that we are concerned by its EBIT growth rate. Looking at all the aforementioned factors together, it strikes us that Jazz Pharmaceuticals can handle its debt fairly comfortably. 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. 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. Be aware that Jazz Pharmaceuticals is showing 3 warning signs in our investment analysis , 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.
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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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