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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Insulet Corporation (NASDAQ:PODD) does use debt in its business. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Insulet's Net Debt?
As you can see below, at the end of June 2022, Insulet had US$1.41b of debt, up from US$1.26b a year ago. Click the image for more detail. However, it also had US$708.6m in cash, and so its net debt is US$702.9m.
A Look At Insulet's Liabilities
Zooming in on the latest balance sheet data, we can see that Insulet had liabilities of US$279.3m due within 12 months and liabilities of US$1.41b due beyond that. Offsetting these obligations, it had cash of US$708.6m as well as receivables valued at US$206.6m due within 12 months. So its liabilities total US$776.1m more than the combination of its cash and short-term receivables.
Of course, Insulet has a titanic market capitalization of US$15.9b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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).
While Insulet's debt to EBITDA ratio (4.5) suggests that it uses some debt, its interest cover is very weak, at 1.9, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Looking on the bright side, Insulet boosted its EBIT by a silky 60% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Insulet'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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Insulet burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Insulet's conversion of EBIT to free cash flow was a real negative on this analysis, as was its interest cover. But like a ballerina ending on a perfect pirouette, it has not trouble growing its EBIT. We would also note that Medical Equipment industry companies like Insulet commonly do use debt without problems. Looking at all this data makes us feel a little cautious about Insulet's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Insulet (of which 1 doesn't sit too well with us!) you should know about.
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.