Is Varex Imaging (NASDAQ:VREX) A Risky Investment?

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.' 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 Varex Imaging Corporation (NASDAQ:VREX) does use debt in its business. 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

See our latest analysis for Varex Imaging

How Much Debt Does Varex Imaging Carry?

You can click the graphic below for the historical numbers, but it shows that Varex Imaging had US$434.5m of debt in October 2021, down from US$455.3m, one year before. On the flip side, it has US$144.6m in cash leading to net debt of about US$289.9m.

A Look At Varex Imaging's Liabilities

We can see from the most recent balance sheet that Varex Imaging had liabilities of US$166.6m falling due within a year, and liabilities of US$484.4m due beyond that. On the other hand, it had cash of US$144.6m and US$155.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$350.8m.

This deficit isn't so bad because Varex Imaging is worth US$1.03b, 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.

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.

While Varex Imaging's debt to EBITDA ratio (2.6) suggests that it uses some debt, its interest cover is very weak, at 1.8, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. One redeeming factor for Varex Imaging is that it turned last year's EBIT loss into a gain of US$75m, over the last twelve months. 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 Varex Imaging'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, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Varex Imaging actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

On our analysis Varex Imaging's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. To be specific, it seems about as good at covering its interest expense with its EBIT as wet socks are at keeping your feet warm. We would also note that Medical Equipment industry companies like Varex Imaging commonly do use debt without problems. When we consider all the elements mentioned above, it seems to us that Varex Imaging is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. To that end, you should be aware of the 1 warning sign we've spotted with Varex Imaging .

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.