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 Patterson Companies, Inc. (NASDAQ:PDCO) makes use of debt. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Patterson Companies Carry?
The image below, which you can click on for greater detail, shows that Patterson Companies had debt of US$750.6m at the end of July 2019, a reduction from US$855.6m over a year. On the flip side, it has US$109.8m in cash leading to net debt of about US$640.8m.
A Look At Patterson Companies's Liabilities
We can see from the most recent balance sheet that Patterson Companies had liabilities of US$874.2m falling due within a year, and liabilities of US$972.0m due beyond that. On the other hand, it had cash of US$109.8m and US$552.8m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.18b.
This deficit is considerable relative to its market capitalization of US$1.62b, so it does suggest shareholders should keep an eye on Patterson Companies's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Patterson Companies has net debt worth 2.4 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 4.6 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. One way Patterson Companies could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 11%, as it did over the last year. 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 Patterson Companies 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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Patterson Companies recorded free cash flow of 40% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Patterson Companies's level of total liabilities and interest cover definitely weigh on it, in our esteem. But it seems to be able to grow its EBIT without much trouble. It's also worth noting that Patterson Companies is in the Healthcare industry, which is often considered to be quite defensive. We think that Patterson Companies's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Patterson Companies's dividend history, without delay!
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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