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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Quest Diagnostics Incorporated (NYSE:DGX) does carry debt. But is this debt a concern to shareholders?
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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Quest Diagnostics Carry?
As you can see below, at the end of September 2020, Quest Diagnostics had US$4.54b of debt, up from US$3.98b a year ago. Click the image for more detail. However, because it has a cash reserve of US$1.61b, its net debt is less, at about US$2.94b.
How Healthy Is Quest Diagnostics's Balance Sheet?
According to the last reported balance sheet, Quest Diagnostics had liabilities of US$2.39b due within 12 months, and liabilities of US$5.23b due beyond 12 months. Offsetting this, it had US$1.61b in cash and US$1.42b in receivables that were due within 12 months. So it has liabilities totalling US$4.59b more than its cash and near-term receivables, combined.
Quest Diagnostics has a very large market capitalization of US$16.8b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
Quest Diagnostics's net debt of 1.5 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 9.5 times its interest expenses harmonizes with that theme. In addition to that, we're happy to report that Quest Diagnostics has boosted its EBIT by 34%, thus reducing the spectre of future debt repayments. 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 Quest Diagnostics 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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 77% 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.
The good news is that Quest Diagnostics's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! We would also note that Healthcare industry companies like Quest Diagnostics commonly do use debt without problems. Zooming out, Quest Diagnostics seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns 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. Case in point: We've spotted 2 warning signs for Quest Diagnostics you should be aware of, and 1 of them is potentially serious.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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