Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, West Pharmaceutical Services, Inc. (NYSE:WST) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. 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, 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.
What Is West Pharmaceutical Services's Net Debt?
The image below, which you can click on for greater detail, shows that at September 2020 West Pharmaceutical Services had debt of US$259.7m, up from US$195.1m in one year. However, its balance sheet shows it holds US$519.4m in cash, so it actually has US$259.7m net cash.
How Healthy Is West Pharmaceutical Services's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that West Pharmaceutical Services had liabilities of US$447.7m due within 12 months and liabilities of US$416.2m due beyond that. On the other hand, it had cash of US$519.4m and US$373.0m worth of receivables due within a year. So it actually has US$28.5m more liquid assets than total liabilities.
Having regard to West Pharmaceutical Services's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the US$20.1b company is struggling for cash, we still think it's worth monitoring its balance sheet. Simply put, the fact that West Pharmaceutical Services has more cash than debt is arguably a good indication that it can manage its debt safely.
On top of that, West Pharmaceutical Services grew its EBIT by 32% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if West Pharmaceutical Services can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. West Pharmaceutical Services may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, West Pharmaceutical Services produced sturdy free cash flow equating to 75% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
While we empathize with investors who find debt concerning, you should keep in mind that West Pharmaceutical Services has net cash of US$259.7m, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 32% over the last year. So is West Pharmaceutical Services's debt a risk? It doesn't seem so to us. Another factor that would give us confidence in West Pharmaceutical Services would be if insiders have been buying shares: if you're conscious of that signal too, you can find out instantly by clicking this link.
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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