Stock Analysis

We Think Zimmer Biomet Holdings (NYSE:ZBH) Is Taking Some Risk With Its Debt

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NYSE:ZBH
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David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Zimmer Biomet Holdings, Inc. (NYSE:ZBH) 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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, 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$7.56b of debt at March 2021, down from US$9.67b a year prior. On the flip side, it has US$724.5m in cash leading to net debt of about US$6.84b.

debt-equity-history-analysis
NYSE:ZBH Debt to Equity History June 22nd 2021

How Healthy Is Zimmer Biomet Holdings' Balance Sheet?

We can see from the most recent balance sheet that Zimmer Biomet Holdings had liabilities of US$2.09b falling due within a year, and liabilities of US$9.49b due beyond that. Offsetting these obligations, it had cash of US$724.5m as well as receivables valued at US$1.38b due within 12 months. So it has liabilities totalling US$9.47b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Zimmer Biomet Holdings has a huge market capitalization of US$34.1b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Zimmer Biomet Holdings has a debt to EBITDA ratio of 3.4 and its EBIT covered its interest expense 4.4 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Worse, Zimmer Biomet Holdings's EBIT was down 30% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Zimmer Biomet Holdings's ability to maintain a healthy balance sheet going forward. 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. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Zimmer Biomet Holdings produced sturdy free cash flow equating to 73% 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.

Our View

Zimmer Biomet Holdings's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its conversion of EBIT to free cash flow was re-invigorating. It's also worth noting that Zimmer Biomet Holdings is in the Medical Equipment industry, which is often considered to be quite defensive. Looking at all the angles mentioned above, it does seem to us that Zimmer Biomet Holdings is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Case in point: We've spotted 2 warning signs for Zimmer Biomet Holdings you should be aware of, and 1 of them doesn't sit too well with us.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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