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.' 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. As with many other companies Laboratory Corporation of America Holdings (NYSE:LH) makes use of 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Laboratory Corporation of America Holdings's Debt?
The image below, which you can click on for greater detail, shows that Laboratory Corporation of America Holdings had debt of US$5.05b at the end of December 2023, a reduction from US$5.34b over a year. However, because it has a cash reserve of US$536.8m, its net debt is less, at about US$4.52b.
How Strong Is Laboratory Corporation of America Holdings' Balance Sheet?
According to the last reported balance sheet, Laboratory Corporation of America Holdings had liabilities of US$3.23b due within 12 months, and liabilities of US$5.61b due beyond 12 months. On the other hand, it had cash of US$536.8m and US$2.10b worth of receivables due within a year. So its liabilities total US$6.20b more than the combination of its cash and short-term receivables.
Laboratory Corporation of America Holdings has a very large market capitalization of US$17.3b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).
Laboratory Corporation of America Holdings has a debt to EBITDA ratio of 2.8 and its EBIT covered its interest expense 6.5 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Shareholders should be aware that Laboratory Corporation of America Holdings's EBIT was down 36% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 Laboratory Corporation of America Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Laboratory Corporation of America Holdings recorded free cash flow worth a fulsome 81% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
Our View
Based on what we've seen Laboratory Corporation of America Holdings is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its conversion of EBIT to free cash flow. We would also note that Healthcare industry companies like Laboratory Corporation of America Holdings commonly do use debt without problems. When we consider all the factors mentioned above, we do feel a bit cautious about Laboratory Corporation of America Holdings's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 4 warning signs for Laboratory Corporation of America Holdings that you should be aware of before investing here.
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.
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This article by Simply Wall St 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. Simply Wall St has no position in any stocks mentioned.