We Think Avanos Medical (NYSE:AVNS) Is Taking Some Risk With Its Debt

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. We can see that Avanos Medical, Inc. (NYSE:AVNS) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Avanos Medical

How Much Debt Does Avanos Medical Carry?

As you can see below, Avanos Medical had US$175.0m of debt at March 2021, down from US$248.2m a year prior. However, it does have US$100.1m in cash offsetting this, leading to net debt of about US$74.9m.

A Look At Avanos Medical's Liabilities

We can see from the most recent balance sheet that Avanos Medical had liabilities of US$154.6m falling due within a year, and liabilities of US$241.6m due beyond that. Offsetting these obligations, it had cash of US$100.1m as well as receivables valued at US$164.3m due within 12 months. So it has liabilities totalling US$131.8m more than its cash and near-term receivables, combined.

Of course, Avanos Medical has a market capitalization of US$1.90b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Avanos Medical has a very low debt to EBITDA ratio of 1.4 so it is strange to see weak interest coverage, with last year's EBIT being only 1.1 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. Shareholders should be aware that Avanos Medical's EBIT was down 43% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Avanos Medical'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last two years, Avanos Medical burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Avanos Medical's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. It's also worth noting that Avanos Medical is in the Medical Equipment industry, which is often considered to be quite defensive. Overall, we think it's fair to say that Avanos Medical has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. While Avanos Medical didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away. Click here to see if its earnings are heading in the right direction, over the medium term.

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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