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. As with many other companies ResMed Inc. (NYSE:RMD) makes use of debt. But is this debt a concern to shareholders?
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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does ResMed Carry?
The image below, which you can click on for greater detail, shows that ResMed had debt of US$731.0m at the end of March 2021, a reduction from US$1.38b over a year. However, it does have US$254.6m in cash offsetting this, leading to net debt of about US$476.4m.
How Healthy Is ResMed's Balance Sheet?
The latest balance sheet data shows that ResMed had liabilities of US$876.5m due within a year, and liabilities of US$999.9m falling due after that. Offsetting these obligations, it had cash of US$254.6m as well as receivables valued at US$537.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.08b.
Since publicly traded ResMed shares are worth a very impressive total of US$31.8b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. But either way, ResMed has virtually no net debt, so it's fair to say it does not have a heavy debt load!
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
ResMed's net debt is only 0.47 times its EBITDA. And its EBIT covers its interest expense a whopping 33.1 times over. So we're pretty relaxed about its super-conservative use of debt. Also good is that ResMed grew its EBIT at 19% 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 ResMed 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 always check how much of that EBIT is translated into free cash flow. During the last three years, ResMed produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
ResMed'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! We would also note that Medical Equipment industry companies like ResMed commonly do use debt without problems. Considering this range of factors, it seems to us that ResMed is quite prudent with its debt, and the risks seem well managed. So the balance sheet looks pretty healthy, to us. Over time, share prices tend to follow earnings per share, so if you're interested in ResMed, you may well want to click here to check an interactive graph of its earnings per share history.
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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