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

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.' 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. Importantly, Smith & Nephew plc (LON:SN.) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Smith & Nephew

What Is Smith & Nephew's Debt?

The image below, which you can click on for greater detail, shows that Smith & Nephew had debt of US$2.72b at the end of July 2022, a reduction from US$3.38b over a year. However, because it has a cash reserve of US$516.0m, its net debt is less, at about US$2.20b.

How Healthy Is Smith & Nephew's Balance Sheet?

We can see from the most recent balance sheet that Smith & Nephew had liabilities of US$2.12b falling due within a year, and liabilities of US$2.59b due beyond that. Offsetting these obligations, it had cash of US$516.0m as well as receivables valued at US$1.25b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.94b.

While this might seem like a lot, it is not so bad since Smith & Nephew has a huge market capitalization of US$11.4b, 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.

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). 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 to EBITDA ratio of about 1.8 suggests only moderate use of debt. And its commanding EBIT of 10.7 times its interest expense, implies the debt load is as light as a peacock feather. We saw Smith & Nephew grow its EBIT by 5.8% 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 ultimately the future profitability of the business will decide if Smith & Nephew can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Smith & Nephew produced sturdy free cash flow equating to 75% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, Smith & Nephew's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And the good news does not stop there, as its interest cover also supports that impression! We would also note that Medical Equipment industry companies like Smith & Nephew commonly do use debt without problems. Taking all this data into account, it seems to us that Smith & Nephew takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Smith & Nephew 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.