Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ 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 Universal Health Services, Inc. (NYSE:UHS) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Universal Health Services’s Net Debt?
As you can see below, Universal Health Services had US$3.61b of debt at March 2021, down from US$3.79b a year prior. On the flip side, it has US$764.5m in cash leading to net debt of about US$2.85b.
How Healthy Is Universal Health Services’ Balance Sheet?
The latest balance sheet data shows that Universal Health Services had liabilities of US$2.24b due within a year, and liabilities of US$4.25b falling due after that. Offsetting this, it had US$764.5m in cash and US$1.67b in receivables that were due within 12 months. So its liabilities total US$4.06b more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Universal Health Services is worth a massive US$13.7b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Universal Health Services’s net debt is only 1.5 times its EBITDA. And its EBIT covers its interest expense a whopping 15.6 times over. So we’re pretty relaxed about its super-conservative use of debt. And we also note warmly that Universal Health Services grew its EBIT by 17% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Universal Health Services can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Universal Health Services recorded free cash flow worth 67% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, Universal Health Services’s impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! We would also note that Healthcare industry companies like Universal Health Services commonly do use debt without problems. Zooming out, Universal Health Services seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. The balance sheet is clearly the area to focus on when you are analysing debt.