Stock Analysis

Is McKesson (NYSE:MCK) A Risky Investment?

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NYSE:MCK
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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. As with many other companies McKesson Corporation (NYSE:MCK) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. 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.

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What Is McKesson's Debt?

As you can see below, McKesson had US$7.31b of debt at December 2020, down from US$9.74b a year prior. However, it does have US$3.58b in cash offsetting this, leading to net debt of about US$3.73b.

debt-equity-history-analysis
NYSE:MCK Debt to Equity History April 7th 2021

A Look At McKesson's Liabilities

The latest balance sheet data shows that McKesson had liabilities of US$41.9b due within a year, and liabilities of US$18.9b falling due after that. Offsetting these obligations, it had cash of US$3.58b as well as receivables valued at US$18.9b due within 12 months. So its liabilities total US$38.4b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's massive market capitalization of US$31.0b, we think shareholders really should watch McKesson's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

McKesson's net debt is only 0.92 times its EBITDA. And its EBIT easily covers its interest expense, being 17.5 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also good is that McKesson grew its EBIT at 15% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if McKesson can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, McKesson actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

The good news is that McKesson's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its level of total liabilities has the opposite effect. It's also worth noting that McKesson is in the Healthcare industry, which is often considered to be quite defensive. Looking at all the aforementioned factors together, it strikes us that McKesson can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for McKesson you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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What are the risks and opportunities for McKesson?

McKesson Corporation provides healthcare services in the United States and internationally.

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Rewards

  • Trading at 25.5% below our estimate of its fair value

  • Earnings are forecast to grow 6.5% per year

  • Became profitable this year

Risks

  • Has a high level of debt

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