These 4 Measures Indicate That Varex Imaging (NASDAQ:VREX) Is Using Debt Reasonably Well

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. As with many other companies Varex Imaging Corporation (NASDAQ:VREX) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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

What Is Varex Imaging's Debt?

As you can see below, Varex Imaging had US$411.0m of debt at April 2022, down from US$460.9m a year prior. However, it also had US$115.1m in cash, and so its net debt is US$295.9m.

How Healthy Is Varex Imaging's Balance Sheet?

We can see from the most recent balance sheet that Varex Imaging had liabilities of US$167.1m falling due within a year, and liabilities of US$461.1m due beyond that. Offsetting these obligations, it had cash of US$115.1m as well as receivables valued at US$154.3m due within 12 months. So its liabilities total US$358.8m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Varex Imaging is worth US$851.0m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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 has a quite reasonable net debt to EBITDA multiple of 2.3, its interest cover seems weak, at 2.3. This does have us wondering if the company pays high interest because it is considered risky. In any case, it's safe to say the company has meaningful debt. Notably, Varex Imaging made a loss at the EBIT level, last year, but improved that to positive EBIT of US$95m in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. 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'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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Varex Imaging produced sturdy free cash flow equating to 64% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Based on what we've seen Varex Imaging is not finding it easy, given its interest cover, but the other factors we considered give us cause to be optimistic. There's no doubt that it has an adequate capacity to convert EBIT to free cash flow. We would also note that Medical Equipment industry companies like Varex Imaging commonly do use debt without problems. Looking at all this data makes us feel a little cautious about Varex Imaging'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. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Varex Imaging has 2 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

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.