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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ 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 can see that Teva Pharmaceutical Industries Limited (NYSE:TEVA) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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, 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.
How Much Debt Does Teva Pharmaceutical Industries Carry?
As you can see below, Teva Pharmaceutical Industries had US$28.6b of debt at March 2019, down from US$30.8b a year prior. However, it does have US$1.97b in cash offsetting this, leading to net debt of about US$26.7b.
A Look At Teva Pharmaceutical Industries’s Liabilities
The latest balance sheet data shows that Teva Pharmaceutical Industries had liabilities of US$14.0b due within a year, and liabilities of US$30.0b falling due after that. Offsetting these obligations, it had cash of US$1.97b as well as receivables valued at US$5.11b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$37.0b.
This deficit casts a shadow over the US$10.3b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Teva Pharmaceutical Industries would probably need a major re-capitalization if its creditors were to demand repayment. Either way, since Teva Pharmaceutical Industries does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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). 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).
With a net debt to EBITDA ratio of 5.97, it’s fair to say Teva Pharmaceutical Industries does have a significant amount of debt. However, its interest coverage of 3.01 is reasonably strong, which is a good sign. Even worse, Teva Pharmaceutical Industries saw its EBIT tank 29% over the last 12 months. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that 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 Teva Pharmaceutical Industries’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Teva Pharmaceutical Industries recorded free cash flow worth 56% 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.
To be frank both Teva Pharmaceutical Industries’s EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. After considering the datapoints 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. Even though Teva Pharmaceutical Industries lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check outhow earnings have been trending over the last few years.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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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.