Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 note that OPKO Health, Inc. (NASDAQ:OPK) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is OPKO Health's Net Debt?
As you can see below, OPKO Health had US$205.1m of debt at June 2021, down from US$286.6m a year prior. However, it does have US$65.8m in cash offsetting this, leading to net debt of about US$139.4m.
How Healthy Is OPKO Health's Balance Sheet?
The latest balance sheet data shows that OPKO Health had liabilities of US$304.0m due within a year, and liabilities of US$375.1m falling due after that. Offsetting these obligations, it had cash of US$65.8m as well as receivables valued at US$275.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$337.7m.
Since publicly traded OPKO Health shares are worth a total of US$2.55b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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).
While OPKO Health's low debt to EBITDA ratio of 0.73 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.2 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Notably, OPKO Health made a loss at the EBIT level, last year, but improved that to positive EBIT of US$110m in the last twelve months. 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 OPKO Health 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, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the most recent year, OPKO Health recorded free cash flow worth 66% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
OPKO Health's net debt to EBITDA suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Looking at all the aforementioned factors together, it strikes us that OPKO Health can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that OPKO Health insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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.
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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