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. As with many other companies Teva Pharmaceutical Industries Limited (NYSE:TEVA) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Teva Pharmaceutical Industries Carry?

As you can see below, Teva Pharmaceutical Industries had US$19.8b of debt at December 2023, down from US$21.2b a year prior. However, it does have US$3.23b in cash offsetting this, leading to net debt of about US$16.6b.

How Healthy Is Teva Pharmaceutical Industries' Balance Sheet?

We can see from the most recent balance sheet that Teva Pharmaceutical Industries had liabilities of US$12.2b falling due within a year, and liabilities of US$23.1b due beyond that. Offsetting these obligations, it had cash of US$3.23b as well as receivables valued at US$3.41b due within 12 months. So its liabilities total US$28.7b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the US$15.8b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Teva Pharmaceutical Industries would likely require a major re-capitalisation if it had to pay its creditors today.

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).

Teva Pharmaceutical Industries has a debt to EBITDA ratio of 3.8 and its EBIT covered its interest expense 3.3 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. On a slightly more positive note, Teva Pharmaceutical Industries grew its EBIT at 19% over the last year, further increasing its ability to manage 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. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Teva Pharmaceutical Industries recorded free cash flow of 24% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We'd go so far as to say Teva Pharmaceutical Industries's level of total liabilities was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that Teva Pharmaceutical Industries's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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 out how 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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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.