The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We can see that Perrigo Company plc (NYSE:PRGO) does use debt in its business. But is this debt a concern to shareholders?
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 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Perrigo’s Net Debt?
As you can see below, Perrigo had US$3.53b of debt, at April 2021, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$473.8m in cash, and so its net debt is US$3.06b.
How Strong Is Perrigo’s Balance Sheet?
The latest balance sheet data shows that Perrigo had liabilities of US$1.45b due within a year, and liabilities of US$4.32b falling due after that. Offsetting these obligations, it had cash of US$473.8m as well as receivables valued at US$659.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.63b.
This is a mountain of leverage relative to its market capitalization of US$6.21b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Perrigo has a debt to EBITDA ratio of 3.7 and its EBIT covered its interest expense 3.1 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. On a slightly more positive note, Perrigo grew its EBIT at 14% 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 Perrigo can strengthen its balance sheet over time.
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, Perrigo recorded free cash flow worth 58% 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.
Our View
Both Perrigo’s interest cover and its net debt to EBITDA were discouraging. At least its EBIT growth rate gives us reason to be optimistic. Looking at all the angles mentioned above, it does seem to us that Perrigo is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start.