Does Smith & Nephew (LON:SN.) Have A Healthy Balance Sheet?

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Smith & Nephew plc (LON:SN.) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Smith & Nephew

How Much Debt Does Smith & Nephew Carry?

As you can see below, at the end of June 2024, Smith & Nephew had US$3.47b of debt, up from US$2.85b a year ago. Click the image for more detail. However, it also had US$568.0m in cash, and so its net debt is US$2.90b.

A Look At Smith & Nephew's Liabilities

According to the last reported balance sheet, Smith & Nephew had liabilities of US$1.78b due within 12 months, and liabilities of US$3.56b due beyond 12 months. On the other hand, it had cash of US$568.0m and US$1.40b worth of receivables due within a year. So it has liabilities totalling US$3.37b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Smith & Nephew is worth a massive US$11.0b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Smith & Nephew's debt is 2.7 times its EBITDA, and its EBIT cover its interest expense 6.4 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. We saw Smith & Nephew grow its EBIT by 5.4% 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 Smith & Nephew'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 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. In the last three years, Smith & Nephew's free cash flow amounted to 30% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Smith & Nephew's conversion of EBIT to free cash flow was a real negative on this analysis, as was its net debt to EBITDA. On the other hand, we found comfort in its relatively strong interest cover. It's also worth noting that Smith & Nephew is in the Medical Equipment industry, which is often considered to be quite defensive. When we consider all the factors mentioned above, we do feel a bit cautious about Smith & Nephew'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. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Smith & Nephew (of which 1 is significant!) 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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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.