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

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 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 should shareholders be worried about its use of debt?

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What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, 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.

What Is Smith & Nephew's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2024 Smith & Nephew had debt of US$3.13b, up from US$2.89b in one year. On the flip side, it has US$619.0m in cash leading to net debt of about US$2.51b.

How Healthy Is Smith & Nephew's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Smith & Nephew had liabilities of US$1.53b due within 12 months and liabilities of US$3.56b due beyond that. On the other hand, it had cash of US$619.0m and US$1.24b worth of receivables due within a year. So it has liabilities totalling US$3.23b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Smith & Nephew is worth a massive US$12.4b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

View our latest analysis for Smith & Nephew

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a debt to EBITDA ratio of 1.9, Smith & Nephew uses debt artfully but responsibly. And the alluring interest cover (EBIT of 7.3 times interest expense) certainly does not do anything to dispel this impression. One way Smith & Nephew could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 20%, as it did over the last year. 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 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Smith & Nephew's free cash flow amounted to 39% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Smith & Nephew's EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And we also thought its interest cover was a positive. We would also note that Medical Equipment industry companies like Smith & Nephew commonly do use debt without problems. Looking at all the aforementioned factors together, it strikes us that Smith & Nephew can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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 Smith & Nephew you should be aware of.

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.