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.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies McKesson Corporation (NYSE:MCK) makes use of debt. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 McKesson’s Debt?

The chart below, which you can click on for greater detail, shows that McKesson had US$7.07b in debt in March 2021; about the same as the year before. However, because it has a cash reserve of US$6.28b, its net debt is less, at about US$788.0m.

How Strong Is McKesson’s Balance Sheet?

We can see from the most recent balance sheet that McKesson had liabilities of US$44.1b falling due within a year, and liabilities of US$19.5b due beyond that. Offsetting these obligations, it had cash of US$6.28b as well as receivables valued at US$19.2b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$38.1b.

Given this deficit is actually higher than the company’s massive market capitalization of US$31.5b, we think shareholders really should watch McKesson’s debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

McKesson has a low net debt to EBITDA ratio of only 0.20. And its EBIT covers its interest expense a whopping 15.2 times over. So we’re pretty relaxed about its super-conservative use of debt. Also good is that McKesson grew its EBIT at 11% over the last year, further increasing its ability to manage 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 McKesson’s ability to maintain a healthy balance sheet going forward.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, McKesson actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

The good news is that McKesson’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its level of total liabilities has the opposite effect. It’s also worth noting that McKesson is in the Healthcare industry, which is often considered to be quite defensive. Looking at all the aforementioned factors together, it strikes us that McKesson can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. There’s no doubt that we learn most about debt from the balance sheet.