We Think Smith & Nephew (LON:SN.) Can Stay On Top Of Its Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Smith & Nephew plc (LON:SN.) makes use of debt. But is this debt a concern to shareholders?

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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Smith & Nephew

How Much Debt Does Smith & Nephew Carry?

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. On the flip side, it has US$516.0m in cash leading to net debt of about US$2.20b.

How Strong 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 it has liabilities totalling US$2.94b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Smith & Nephew is worth a massive US$11.1b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

We'd say that Smith & Nephew's moderate net debt to EBITDA ratio ( being 1.8), indicates prudence when it comes to debt. And its commanding EBIT of 10.7 times its interest expense, implies the debt load is as light as a peacock feather. Smith & Nephew grew its EBIT by 5.8% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. There's no doubt that we learn most about debt from the balance sheet. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Smith & Nephew recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that Smith & Nephew's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its interest cover 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. When we consider the range of factors above, it looks like Smith & Nephew is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Smith & Nephew that 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.