Here's Why Quest Diagnostics (NYSE:DGX) Can Manage Its Debt Responsibly

Warren Buffett famously said, '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 Quest Diagnostics Incorporated (NYSE:DGX) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Quest Diagnostics

How Much Debt Does Quest Diagnostics Carry?

The image below, which you can click on for greater detail, shows that at June 2023 Quest Diagnostics had debt of US$4.30b, up from US$3.98b in one year. However, because it has a cash reserve of US$126.0m, its net debt is less, at about US$4.17b.

How Strong Is Quest Diagnostics' Balance Sheet?

The latest balance sheet data shows that Quest Diagnostics had liabilities of US$1.88b due within a year, and liabilities of US$5.19b falling due after that. Offsetting this, it had US$126.0m in cash and US$1.24b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$5.70b.

Quest Diagnostics has a very large market capitalization of US$13.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Quest Diagnostics's net debt of 2.4 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 9.5 times interest expense) certainly does not do anything to dispel this impression. Shareholders should be aware that Quest Diagnostics's EBIT was down 39% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 Quest Diagnostics'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Quest Diagnostics recorded free cash flow worth 73% 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.

Our View

Quest Diagnostics's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to convert EBIT to free cash flow is pretty flash. It's also worth noting that Quest Diagnostics is in the Healthcare industry, which is often considered to be quite defensive. When we consider all the factors mentioned above, we do feel a bit cautious about Quest Diagnostics's use of debt. 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. 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. Case in point: We've spotted 2 warning signs for Quest Diagnostics you should be aware of.

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.