Is Universal Health Services (NYSE:UHS) Using Too Much Debt?

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Universal Health Services, Inc. (NYSE:UHS) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Universal Health Services

What Is Universal Health Services's Net Debt?

As you can see below, at the end of September 2023, Universal Health Services had US$4.92b of debt, up from US$4.70b a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.

How Healthy Is Universal Health Services' Balance Sheet?

The latest balance sheet data shows that Universal Health Services had liabilities of US$1.99b due within a year, and liabilities of US$5.77b falling due after that. On the other hand, it had cash of US$80.8m and US$2.23b worth of receivables due within a year. So it has liabilities totalling US$5.45b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Universal Health Services has a huge market capitalization of US$11.1b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Universal Health Services has a debt to EBITDA ratio of 2.8 and its EBIT covered its interest expense 6.0 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Universal Health Services grew its EBIT by 7.0% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Universal Health Services 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Universal Health Services reported free cash flow worth 15% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Universal Health Services's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its EBIT growth rate is relatively strong. It's also worth noting that Universal Health Services is in the Healthcare industry, which is often considered to be quite defensive. We think that Universal Health Services's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. For example - Universal Health Services has 1 warning sign we think you should be aware of.

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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