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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.’ 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. We note that PRA Health Sciences, Inc. (NASDAQ:PRAH) does have debt on its balance sheet. 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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does PRA Health Sciences Carry?
You can click the graphic below for the historical numbers, but it shows that PRA Health Sciences had US$1.08b of debt in March 2019, down from US$1.34b, one year before However, because it has a cash reserve of US$177.1m, its net debt is less, at about US$905.6m.
How Healthy Is PRA Health Sciences’s Balance Sheet?
According to the last reported balance sheet, PRA Health Sciences had liabilities of US$950.7m due within 12 months, and liabilities of US$1.37b due beyond 12 months. Offsetting these obligations, it had cash of US$177.1m as well as receivables valued at US$597.2m due within 12 months. So its liabilities total US$1.55b more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because PRA Health Sciences is worth US$6.35b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution. Either way, since PRA Health Sciences does have more debt than cash, it’s worth keeping an eye on its balance sheet.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
PRA Health Sciences has net debt worth 2.02 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 6.91 times the interest expense. While these numbers do not alarm us, it’s worth noting that the cost of the company’s debt is having a real impact. We note that PRA Health Sciences grew its EBIT by 24% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if PRA Health Sciences 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, PRA Health Sciences recorded free cash flow worth 73% 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.
The good news is that PRA Health Sciences’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And that’s just the beginning of the good news since its EBIT growth rate is also very heartening. Taking all this data into account, it seems to us that PRA Health Sciences takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Over time, share prices tend to follow earnings per share, so if you’re interested in PRA Health Sciences, you may well want to click here to check an interactive graph of its earnings per share history.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.