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. We can see that West Pharmaceutical Services, Inc. (NYSE:WST) does use debt in its business. But is this debt a concern to shareholders?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is West Pharmaceutical Services's Debt?
The chart below, which you can click on for greater detail, shows that West Pharmaceutical Services had US$254.1m in debt in June 2021; about the same as the year before. But on the other hand it also has US$576.2m in cash, leading to a US$322.1m net cash position.
How Healthy Is West Pharmaceutical Services' Balance Sheet?
According to the last reported balance sheet, West Pharmaceutical Services had liabilities of US$472.6m due within 12 months, and liabilities of US$428.3m due beyond 12 months. Offsetting this, it had US$576.2m in cash and US$480.5m in receivables that were due within 12 months. So it actually has US$155.8m more liquid assets than total liabilities.
This state of affairs indicates that West Pharmaceutical Services' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the US$34.0b company is struggling for cash, we still think it's worth monitoring its balance sheet. Succinctly put, West Pharmaceutical Services boasts net cash, so it's fair to say it does not have a heavy debt load!
On top of that, West Pharmaceutical Services grew its EBIT by 81% 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.
Finally, while the tax-man may adore accounting profits, lenders only accept 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 62% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While we empathize with investors who find debt concerning, you should keep in mind that West Pharmaceutical Services has net cash of US$322.1m, as well as more liquid assets than liabilities. And we liked the look of last year's 81% year-on-year EBIT growth. So we don't think West Pharmaceutical Services's use of debt is risky. 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. We've identified 1 warning sign with West Pharmaceutical Services , and understanding them should be part of your investment process.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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