In the world of investing, the possibility of permanent loss is a risk that concerns every practical investor. This sentiment was echoed by Howard Marks, who emphasized the significance of considering debt when evaluating the riskiness of a stock. Excessive debt can pose a threat to a company’s stability and ultimately lead to its downfall.
One company that carries a considerable amount of debt is Medtronic plc (NYSE: MDT). This raises the important question: how much risk does this debt create for the company?
Debt becomes dangerous for a business when it cannot fulfill its obligations, either through free cash flow or by raising capital at an attractive price. The worst-case scenario is bankruptcy, where a company is unable to pay its creditors. Another challenging scenario is when a company must raise new equity capital at a low price, resulting in a permanent dilution of shareholders.
However, debt can also be a useful tool for businesses, especially those that require substantial capital. It is crucial to assess a company’s cash and debt together when evaluating its debt levels. As of July 2023, Medtronic had a debt of US$24.9 billion, up from US$23.2 billion the previous year. However, the company also had US$7.88 billion in cash, resulting in a net debt of US$17.0 billion.
Analyzing Medtronic’s balance sheet, we find that the company had liabilities of US$9.05 billion due within a year and US$30.4 billion due beyond that. On the flip side, it had US$7.88 billion in cash and US$5.81 billion worth of receivables due within a year. This means that Medtronic’s liabilities exceed its cash and near-term receivables by a total of US$25.7 billion.
Despite this deficit, Medtronic’s substantial worth of US$106.8 billion implies that it could potentially raise enough capital to address its balance sheet concerns if the need arises. Nevertheless, it is essential to closely examine the company’s ability to pay off its debt.
To evaluate a company’s debt relative to its earnings, financial analysts often calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA). Additionally, they consider its earnings before interest and tax (EBIT) divided by its interest expense (interest cover). These metrics help assess the quantum of the debt as well as the interest rates associated with it.
Medtronic’s net debt to EBITDA ratio stands at approximately 2.0, indicating a moderate use of debt. Moreover, its strong interest cover of 46.2 times provides a sense of security. However, it is worth noting that Medtronic’s EBIT declined by 7.4% in the last year, which could present difficulties in managing its debt going forward.
Apart from analyzing debt levels, it is crucial to assess a company’s future profitability when evaluating the overall strength of its balance sheet. Medtronic, with its strong free cash flow generating capacity, has been able to pay down debt effectively. Over the past three years, the company generated free cash flow amounting to 85% of its EBIT.
In conclusion, while Medtronic’s interest cover suggests that it can manage its debt, the decline in its EBIT growth rate raises some concerns. It is worth noting that Medical Equipment industry companies, like Medtronic, often utilize debt without issues. Therefore, considering all the factors, Medtronic appears to employ debt prudently, which can enhance returns for shareholders.
It is important to keep in mind that every company carries risks that extend beyond its balance sheet. For a comprehensive assessment, investors should consider additional factors. In the case of Medtronic, there are a few warning signs that investors should be aware of.
Source: Previous article by Simply Wall St.