These 4 Measures Indicate That Smith & Nephew (LON:SN.) Is Using Debt Safely

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We can see that Smith & Nephew plc (LON:SN.) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Smith & Nephew

What Is Smith & Nephew's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Smith & Nephew had US$3.14b of debt in December 2021, down from US$3.49b, one year before. However, because it has a cash reserve of US$1.29b, its net debt is less, at about US$1.85b.

How Strong Is Smith & Nephew's Balance Sheet?

The latest balance sheet data shows that Smith & Nephew had liabilities of US$2.13b due within a year, and liabilities of US$3.22b falling due after that. Offsetting these obligations, it had cash of US$1.29b as well as receivables valued at US$1.17b due within 12 months. So it has liabilities totalling US$2.89b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Smith & Nephew is worth a massive US$14.1b, 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). 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).

Smith & Nephew's net debt of 1.6 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 9.6 times interest expense) certainly does not do anything to dispel this impression. In addition to that, we're happy to report that Smith & Nephew has boosted its EBIT by 64%, thus reducing the spectre of future debt repayments. 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'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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Smith & Nephew generated free cash flow amounting to a very robust 81% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Smith & Nephew'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. And the good news does not stop there, as its EBIT growth rate also supports that impression! It's also worth noting that Smith & Nephew is in the Medical Equipment industry, which is often considered to be quite defensive. Overall, we don't think Smith & Nephew is taking any bad risks, as its debt load seems modest. So the balance sheet looks pretty healthy, to us. Another factor that would give us confidence in Smith & Nephew would be if insiders have been buying shares: if you're conscious of that signal too, you can find out instantly by clicking this link.

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.