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. We can see that Teleflex Incorporated (NYSE:TFX) does use debt in its business. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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.
What Is Teleflex’s Debt?
As you can see below, Teleflex had US$2.06b of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$506.9m in cash, and so its net debt is US$1.55b.
How Healthy Is Teleflex’s Balance Sheet?
According to the last reported balance sheet, Teleflex had liabilities of US$562.2m due within 12 months, and liabilities of US$2.82b due beyond 12 months. Offsetting these obligations, it had cash of US$506.9m as well as receivables valued at US$399.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.48b.
Given Teleflex has a humongous market capitalization of US$14.6b, it’s hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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).
Teleflex’s net debt of 2.0 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 8.9 times interest expense) certainly does not do anything to dispel this impression. We note that Teleflex grew its EBIT by 29% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Teleflex can strengthen its balance sheet over time.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Teleflex generated free cash flow amounting to a very robust 81% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
The good news is that Teleflex’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its EBIT growth rate also supports that impression! It’s also worth noting that Teleflex is in the Medical Equipment industry, which is often considered to be quite defensive. Overall, we don’t think Teleflex is taking any bad risks, as its debt load seems modest. So the balance sheet looks pretty healthy, to us. When analysing debt levels, the balance sheet is the obvious place to start.