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.’ 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. We note that Universal Health Services, Inc. (NYSE:UHS) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Universal Health Services’s Debt?
The chart below, which you can click on for greater detail, shows that Universal Health Services had US$4.15b in debt in June 2019; about the same as the year before. Net debt is about the same, since the it doesn’t have much cash.
A Look At Universal Health Services’s Liabilities
Zooming in on the latest balance sheet data, we can see that Universal Health Services had liabilities of US$1.54b due within 12 months and liabilities of US$4.74b due beyond that. On the other hand, it had cash of US$61.3m and US$1.60b worth of receivables due within a year. So its liabilities total US$4.62b more than the combination of its cash and short-term receivables.
Universal Health Services has a very large market capitalization of US$13.6b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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).
With a debt to EBITDA ratio of 2.4, Universal Health Services uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 7.8 times its interest expenses harmonizes with that theme. Notably Universal Health Services’s EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Universal Health Services’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, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Universal Health Services recorded free cash flow of 47% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
On our analysis Universal Health Services’s interest cover should signal that it won’t have too much trouble with its debt. However, our other observations weren’t so heartening. For example, its net debt to EBITDA makes us a little nervous about its debt. We would also note that Healthcare industry companies like Universal Health Services commonly do use debt without problems. When we consider all the factors mentioned above, we do feel a bit cautious about Universal Health Services’s use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. Over time, share prices tend to follow earnings per share, so if you’re interested in Universal Health Services, you may well want to click here to check an interactive graph of its earnings per share history.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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