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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.’ 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. Importantly, Stryker Corporation (NYSE:SYK) does carry debt. But should shareholders be worried about its use of debt?
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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Stryker’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Stryker had US$8.47b of debt, an increase on US$7.90b, over one year. However, because it has a cash reserve of US$1.76b, its net debt is less, at about US$6.71b.
How Healthy Is Stryker’s Balance Sheet?
We can see from the most recent balance sheet that Stryker had liabilities of US$3.71b falling due within a year, and liabilities of US$10.5b due beyond that. On the other hand, it had cash of US$1.76b and US$2.28b worth of receivables due within a year. So its liabilities total US$10.2b more than the combination of its cash and short-term receivables.
Given Stryker has a humongous market capitalization of US$77.6b, it’s hard to believe these liabilities pose much threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse. Because it carries more debt than cash, we think it’s worth watching Stryker’s balance sheet over time.
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).
Stryker’s net debt to EBITDA ratio of about 1.72 suggests only moderate use of debt. And its strong interest cover of 24.5 times, makes us even more comfortable. One way Stryker could vanquish its debt would be if it stops borrowing more but conitinues to grow EBIT at around 12%, as it did over the last year. 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 Stryker’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 always check how much of that EBIT is translated into free cash flow. During the last three years, Stryker produced sturdy free cash flow equating to 52% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
The good news is that Stryker’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And its EBIT growth rate is good too. We would also note that Medical Equipment industry companies like Stryker commonly do use debt without problems. When we consider the range of factors above, it looks like Stryker is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. We’d be motivated to research the stock further if we found out that Stryker insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
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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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.