Stock Analysis

Here's Why Zimmer Biomet Holdings (NYSE:ZBH) Can Manage Its Debt Responsibly

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NYSE:ZBH
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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 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. Importantly, Zimmer Biomet Holdings, Inc. (NYSE:ZBH) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Zimmer Biomet Holdings

What Is Zimmer Biomet Holdings's Debt?

As you can see below, Zimmer Biomet Holdings had US$7.87b of debt at June 2021, down from US$8.21b a year prior. However, it also had US$1.04b in cash, and so its net debt is US$6.82b.

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NYSE:ZBH Debt to Equity History October 4th 2021

A Look At Zimmer Biomet Holdings' Liabilities

According to the last reported balance sheet, Zimmer Biomet Holdings had liabilities of US$2.93b due within 12 months, and liabilities of US$8.71b due beyond 12 months. On the other hand, it had cash of US$1.04b and US$1.42b worth of receivables due within a year. So its liabilities total US$9.18b more than the combination of its cash and short-term receivables.

Zimmer Biomet Holdings has a very large market capitalization of US$31.2b, 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).

Zimmer Biomet Holdings has a debt to EBITDA ratio of 2.8 and its EBIT covered its interest expense 6.3 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. It is well worth noting that Zimmer Biomet Holdings's EBIT shot up like bamboo after rain, gaining 44% in the last twelve months. That'll make it easier to manage its 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 Zimmer Biomet Holdings 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Zimmer Biomet Holdings recorded free cash flow worth 77% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Zimmer Biomet Holdings's EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its net debt to EBITDA. It's also worth noting that Zimmer Biomet Holdings is in the Medical Equipment industry, which is often considered to be quite defensive. Zooming out, Zimmer Biomet Holdings seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Zimmer Biomet Holdings (of which 1 makes us a bit uncomfortable!) you should know about.

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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