Does ConvaTec Group (LON:CTEC) Have A Healthy Balance Sheet?

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that ConvaTec Group Plc (LON:CTEC) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for ConvaTec Group

What Is ConvaTec Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that ConvaTec Group had US$1.35b of debt in June 2022, down from US$1.45b, one year before. However, it also had US$271.6m in cash, and so its net debt is US$1.08b.

How Healthy Is ConvaTec Group's Balance Sheet?

We can see from the most recent balance sheet that ConvaTec Group had liabilities of US$647.7m falling due within a year, and liabilities of US$1.45b due beyond that. Offsetting these obligations, it had cash of US$271.6m as well as receivables valued at US$348.3m due within 12 months. So it has liabilities totalling US$1.48b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since ConvaTec Group has a market capitalization of US$4.72b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

ConvaTec Group's debt is 2.8 times its EBITDA, and its EBIT cover its interest expense 5.5 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Unfortunately, ConvaTec Group's EBIT flopped 14% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine ConvaTec Group's ability to maintain a healthy balance sheet going forward. 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. Happily for any shareholders, ConvaTec Group actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

On our analysis ConvaTec Group's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. To be specific, it seems about as good at (not) growing its EBIT as wet socks are at keeping your feet warm. We would also note that Medical Equipment industry companies like ConvaTec Group commonly do use debt without problems. When we consider all the factors mentioned above, we do feel a bit cautious about ConvaTec Group's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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 ConvaTec Group is showing 4 warning signs in our investment analysis , you should know about...

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.