Here's Why ConvaTec Group (LON:CTEC) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 is this debt a concern to shareholders?

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

See our latest analysis for ConvaTec Group

What Is ConvaTec Group's Net Debt?

The chart below, which you can click on for greater detail, shows that ConvaTec Group had US$1.46b in debt in December 2020; about the same as the year before. However, it also had US$565.4m in cash, and so its net debt is US$898.7m.

How Strong Is ConvaTec Group's Balance Sheet?

The latest balance sheet data shows that ConvaTec Group had liabilities of US$513.2m due within a year, and liabilities of US$1.58b falling due after that. On the other hand, it had cash of US$565.4m and US$289.5m worth of receivables due within a year. So its liabilities total US$1.24b more than the combination of its cash and short-term receivables.

Since publicly traded ConvaTec Group shares are worth a total of US$6.37b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

ConvaTec Group has net debt worth 2.3 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 5.3 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. We saw ConvaTec Group grow its EBIT by 4.8% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. 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 ConvaTec Group'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, ConvaTec Group actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Happily, ConvaTec Group's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And we also thought its EBIT growth rate was a positive. We would also note that Medical Equipment industry companies like ConvaTec Group commonly do use debt without problems. When we consider the range of factors above, it looks like ConvaTec Group is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that ConvaTec Group is showing 2 warning signs in our investment analysis , you should know about...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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