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. Importantly, Teva Pharmaceutical Industries Limited ( NYSE:TEVA ) does carry debt. But should shareholders be worried about its use of debt?
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.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.
The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Teva Pharmaceutical Industries's Debt?
The image below shows that Teva Pharmaceutical Industries had debt of US$24.9b at the end of March 2021, a reduction from US$26.1b over a year.However, it also had US$1.74b in cash, and so its net debt is US$23.1b.
How Healthy Is Teva Pharmaceutical Industries' Balance Sheet?
The latest balance sheet data shows that Teva Pharmaceutical Industries had liabilities of US$12.1b due within a year, and liabilities of US$25.9b falling due after that.On the other hand, it had cash of US$1.74b and US$4.57b worth of receivables due within a year.So, its liabilities total US$31.7b more than the combination of its cash and short-term receivables.
----So we'd watch its balance sheet closely, without a doubt.After all, Teva Pharmaceutical Industries would likely require a major recapitalization if it had to pay its creditors today.
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).This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Teva Pharmaceutical Industries has a rather high debt to EBITDA ratio of 5.3 which suggests a meaningful debt load.
The good news is that it boasts a fairly comforting 3x interest coverage ratio, suggesting it can responsibly service its obligations.Even more troubling is the fact that Teva Pharmaceutical Industries actually let its EBIT decrease by 4.8% over the last year.If such an earnings trend continues, the company will face an uphill battle to pay off 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 Teva Pharmaceutical Industries can strengthen its balance sheet over time.
I f you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Our final consideration is concerning the company's lack of cash to finance its debt. We always check how much EBIT is translated into free cash flow.In the last three years, Teva Pharmaceutical Industries created free cash flow amounting to 8.9% of its EBIT, an uninspiring performance.For us, cash conversion that low sparks a little paranoia about its ability to extinguish debt.
To be frank, both Teva Pharmaceutical Industries's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels.And even its interest cover fails to inspire much confidence.After considering the data points discussed, we think Teva Pharmaceutical Industries has too much debt.While some investors love that sort of risky play, it's certainly not our cup of tea.When analyzing 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. We've identified 1 warning sign with Teva Pharmaceutical Industries , and understanding them should be part of your investment process.
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.
Simply Wall St analyst Goran Damchevski and Simply Wall St have no position in any of the companies mentioned. This article 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.