Quest Diagnostics (NYSE:DGX) Seems To Use Debt Quite Sensibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies Quest Diagnostics Incorporated (NYSE:DGX) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Quest Diagnostics

What Is Quest Diagnostics's Net Debt?

As you can see below, Quest Diagnostics had US$3.99b of debt, at June 2022, which is about the same as the year before. You can click the chart for greater detail. However, it does have US$790.0m in cash offsetting this, leading to net debt of about US$3.20b.

A Look At Quest Diagnostics' Liabilities

Zooming in on the latest balance sheet data, we can see that Quest Diagnostics had liabilities of US$1.58b due within 12 months and liabilities of US$5.21b due beyond that. On the other hand, it had cash of US$790.0m and US$1.29b worth of receivables due within a year. So it has liabilities totalling US$4.70b more than its cash and near-term receivables, combined.

Quest Diagnostics has a very large market capitalization of US$14.9b, so it could very likely raise cash to ameliorate 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.

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 has a low net debt to EBITDA ratio of only 1.2. And its EBIT covers its interest expense a whopping 14.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Quest Diagnostics's saving grace is its low debt levels, because its EBIT has tanked 26% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Quest Diagnostics produced sturdy free cash flow equating to 74% of its EBIT, about what we'd expect. 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 cover its interest expense with its EBIT is pretty flash. It's also worth noting that Quest Diagnostics is in the Healthcare industry, which is often considered to be quite defensive. Considering this range of data points, we think Quest Diagnostics is in a good position to manage its debt levels. 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. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Quest Diagnostics that you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.