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. So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. As with many other companies Merck & Co., Inc. (NYSE:MRK) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Merck’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Merck had US$26.6b of debt, an increase on US$23.5b, over one year. However, because it has a cash reserve of US$7.11b, its net debt is less, at about US$19.5b.
How Healthy Is Merck’s Balance Sheet?
We can see from the most recent balance sheet that Merck had liabilities of US$20.1b falling due within a year, and liabilities of US$36.1b due beyond that. Offsetting these obligations, it had cash of US$7.11b as well as receivables valued at US$8.21b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$40.9b.
Given Merck has a humongous market capitalization of US$216.8b, it’s hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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.
Merck has a low net debt to EBITDA ratio of only 1.1. And its EBIT easily covers its interest expense, being 27.1 times the size. So we’re pretty relaxed about its super-conservative use of debt. On top of that, Merck grew its EBIT by 98% over the last twelve months, and that growth will make it easier to handle its 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 Merck’s ability to maintain a healthy balance sheet going forward. 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 we always check how much of that EBIT is translated into free cash flow. During the last three years, Merck produced sturdy free cash flow equating to 70% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Merck’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. And that’s just the beginning of the good news since its EBIT growth rate is also very heartening. Zooming out, Merck seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you’ve also come to that realization, you’re in luck, because today you can view this interactive graph of Merck’s earnings per share history for free.
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.
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