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.' 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 Teva Pharmaceutical Industries Limited (NYSE:TEVA) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is Teva Pharmaceutical Industries's Net Debt?
As you can see below, Teva Pharmaceutical Industries had US$24.9b of debt at March 2021, down from US$26.1b a year prior. On the flip side, it has US$1.74b in cash leading to net debt of about US$23.1b.
A Look At Teva Pharmaceutical Industries' Liabilities
Zooming in on the latest balance sheet data, we can see that Teva Pharmaceutical Industries had liabilities of US$12.1b due within 12 months and liabilities of US$25.9b due beyond that. Offsetting these obligations, it had cash of US$1.74b as well as receivables valued at US$4.57b due within 12 months. So it has liabilities totalling US$31.7b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the US$11.6b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Teva Pharmaceutical Industries would likely require a major re-capitalisation 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a net debt to EBITDA ratio of 5.3, it's fair to say Teva Pharmaceutical Industries does have a significant amount of debt. However, its interest coverage of 3.0 is reasonably strong, which is a good sign. Even more troubling is the fact that Teva Pharmaceutical Industries actually let its EBIT decrease by 4.8% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. 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. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Teva Pharmaceutical Industries reported free cash flow worth 8.9% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down 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. Taking into account all the aforementioned factors, it looks like Teva Pharmaceutical Industries has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. While Teva Pharmaceutical Industries didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away. Click here to see if its earnings are heading in the right direction, over the medium term.
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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