We Think ConvaTec Group (LON:CTEC) Can Stay On Top Of Its Debt

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. We note that ConvaTec Group Plc (LON:CTEC) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. 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. 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.

Check out our latest analysis for ConvaTec Group

What Is ConvaTec Group's Net Debt?

The image below, which you can click on for greater detail, shows that ConvaTec Group had debt of US$1.35b at the end of December 2021, a reduction from US$1.46b over a year. However, it also had US$463.4m in cash, and so its net debt is US$884.1m.

How Healthy Is ConvaTec Group's Balance Sheet?

We can see from the most recent balance sheet that ConvaTec Group had liabilities of US$569.2m falling due within a year, and liabilities of US$1.41b due beyond that. On the other hand, it had cash of US$463.4m and US$323.5m worth of receivables due within a year. So its liabilities total US$1.19b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since ConvaTec Group has a market capitalization of US$4.94b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

ConvaTec Group has net debt worth 2.2 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 that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. We saw ConvaTec Group grow its EBIT by 2.8% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. 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'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 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. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

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. It's also worth noting that ConvaTec Group is in the Medical Equipment industry, which is often considered to be quite defensive. Looking at all the aforementioned factors together, it strikes us that ConvaTec Group 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. 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. Case in point: We've spotted 2 warning signs for ConvaTec Group you should be aware of.

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.