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.' 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. We can see that Universal Health Services, Inc. (NYSE:UHS) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Universal Health Services Carry?
As you can see below, Universal Health Services had US$3.80b of debt at December 2020, down from US$3.97b a year prior. However, because it has a cash reserve of US$1.22b, its net debt is less, at about US$2.58b.
A Look At Universal Health Services' Liabilities
Zooming in on the latest balance sheet data, we can see that Universal Health Services had liabilities of US$2.48b due within 12 months and liabilities of US$4.59b due beyond that. On the other hand, it had cash of US$1.22b and US$1.73b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.12b.
While this might seem like a lot, it is not so bad since Universal Health Services has a huge market capitalization of US$11.7b, 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). 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).
Universal Health Services's net debt is only 1.4 times its EBITDA. And its EBIT covers its interest expense a whopping 12.9 times over. So we're pretty relaxed about its super-conservative use of debt. Fortunately, Universal Health Services grew its EBIT by 3.6% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Universal Health Services produced sturdy free cash flow equating to 76% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Universal Health Services'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 that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. We would also note that Healthcare industry companies like Universal Health Services commonly do use debt without problems. When we consider the range of factors above, it looks like Universal Health Services is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Universal Health Services , and understanding them should be part of your investment process.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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