Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Baxter International Inc. (NYSE:BAX) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Baxter International's Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Baxter International had US$6.57b of debt, an increase on US$5.11b, over one year. However, it also had US$4.36b in cash, and so its net debt is US$2.21b.
A Look At Baxter International's Liabilities
We can see from the most recent balance sheet that Baxter International had liabilities of US$3.42b falling due within a year, and liabilities of US$8.07b due beyond that. Offsetting these obligations, it had cash of US$4.36b as well as receivables valued at US$2.00b due within 12 months. So its liabilities total US$5.14b more than the combination of its cash and short-term receivables.
Since publicly traded Baxter International shares are worth a very impressive total of US$42.1b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Baxter International's net debt is only 0.80 times its EBITDA. And its EBIT easily covers its interest expense, being 16.7 times the size. So we're pretty relaxed about its super-conservative use of debt. The good news is that Baxter International has increased its EBIT by 3.0% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Baxter International 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Baxter International recorded free cash flow worth 63% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Baxter International's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its net debt to EBITDA also supports that impression! It's also worth noting that Baxter International is in the Medical Equipment industry, which is often considered to be quite defensive. Looking at the bigger picture, we think Baxter International's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 3 warning signs we've spotted with Baxter International .
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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What are the risks and opportunities for Baxter International?
Trading at 39.8% below our estimate of its fair value
Earnings are forecast to grow 64.32% per year
Debt is not well covered by operating cash flow
This article by Simply Wall St is general in nature. 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.
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