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.’ 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 note that Hologic, Inc. (NASDAQ:HOLX) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Hologic’s Debt?
The image below, which you can click on for greater detail, shows that Hologic had debt of US$3.14b at the end of June 2021, a reduction from US$3.33b over a year. However, it also had US$827.6m in cash, and so its net debt is US$2.31b.
How Healthy Is Hologic’s Balance Sheet?
The latest balance sheet data shows that Hologic had liabilities of US$1.46b due within a year, and liabilities of US$3.25b falling due after that. Offsetting this, it had US$827.6m in cash and US$943.2m in receivables that were due within 12 months. So its liabilities total US$2.94b more than the combination of its cash and short-term receivables.
Since publicly traded Hologic shares are worth a very impressive total of US$19.5b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Hologic’s net debt is only 0.75 times its EBITDA. And its EBIT easily covers its interest expense, being 28.5 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, Hologic grew its EBIT by 301% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Hologic’s ability to maintain a healthy balance sheet going forward.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Hologic recorded free cash flow worth a fulsome 82% of its EBIT, which is stronger than we’d usually expect. That puts it in a very strong position to pay down debt.
Happily, Hologic’s impressive interest cover implies it has the upper hand on its debt. And that’s just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. We would also note that Medical Equipment industry companies like Hologic commonly do use debt without problems. It looks Hologic has no trouble standing on its own two feet, and it has no reason to fear its lenders. For investing nerds like us its balance sheet is almost charming. The balance sheet is clearly the area to focus on when you are analysing debt.