Is ConvaTec Group (LON:CTEC) A Risky Investment?

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 ConvaTec Group PLC (LON:CTEC) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for ConvaTec Group

How Much Debt Does ConvaTec Group Carry?

The image below, which you can click on for greater detail, shows that ConvaTec Group had debt of US$1.21b at the end of December 2022, a reduction from US$1.35b over a year. However, because it has a cash reserve of US$145.8m, its net debt is less, at about US$1.07b.

How Strong Is ConvaTec Group's Balance Sheet?

We can see from the most recent balance sheet that ConvaTec Group had liabilities of US$533.1m falling due within a year, and liabilities of US$1.45b due beyond that. On the other hand, it had cash of US$145.8m and US$339.3m worth of receivables due within a year. So it has liabilities totalling US$1.50b more than its cash and near-term receivables, combined.

ConvaTec Group has a market capitalization of US$5.71b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

ConvaTec Group has net debt worth 2.5 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 5.9 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. If ConvaTec Group can keep growing EBIT at last year's rate of 11% 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 ConvaTec Group 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, ConvaTec Group recorded free cash flow worth a fulsome 93% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

ConvaTec Group's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its net debt to EBITDA. It's also worth noting that ConvaTec Group is in the Medical Equipment industry, which is often considered to be quite defensive. 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that ConvaTec Group is showing 4 warning signs in our investment analysis , and 1 of those is concerning...

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. 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.