Laboratory Corporation of America Holdings (NYSE:LH) seems to be using debt quite wisely

Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. We can see that Laboratory Corporation of America Holdings (NYSE: LH) uses debt in its operations. But the real question is whether this debt makes the business risky.

When is debt a problem?

Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.

Check out our latest analysis for Laboratory Corporation of America Holdings

What is the net debt of Laboratory Corporation of America Holdings?

You can click on the chart below for historical numbers, but it shows Laboratory Corporation of America Holdings had US$5.42 billion in debt in December 2021, up from US$5.80 billion a year earlier. However, he has $1.47 billion in cash to offset this, resulting in a net debt of around $3.95 billion.

A look at the liabilities of Laboratory Corporation of America Holdings

The latest balance sheet data shows that Laboratory Corporation of America Holdings had liabilities of $2.78 billion due within the year, and liabilities of $7.31 billion due thereafter. As compensation for these obligations, it had cash of US$1.47 billion and receivables valued at US$2.98 billion due within 12 months. It therefore has liabilities totaling $5.64 billion more than its cash and short-term receivables, combined.

This shortfall isn’t that bad, as Laboratory Corporation of America Holdings is worth US$25.1 billion and therefore could probably raise enough capital to shore up its balance sheet, should the need arise. But it is clear that it is essential to examine closely whether it can manage its debt without dilution.

We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).

Laboratory Corporation of America Holdings has a low net debt to EBITDA ratio of just 0.97. And its EBIT easily covers its interest charges, which is 17.3 times the size. One could therefore say that he is no more threatened by his debt than an elephant is by a mouse. Another good thing is that Laboratory Corporation of America Holdings increased its EBIT by 15% over the past year, further increasing its ability to manage debt. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Laboratory Corporation of America Holdings’ ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

Finally, a business needs free cash flow to pay off its debts; book profits are not enough. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, Laboratory Corporation of America Holdings has had free cash flow of 69% of its EBIT, which is about normal given that free cash flow excludes interest and taxes. This free cash flow puts the company in a good position to repay its debt, should it arise.

Our point of view

The good news is that Laboratory Corporation of America Holdings’ demonstrated ability to cover its interest costs with its EBIT delights us like a fluffy puppy does a toddler. And this is only the beginning of good news since its conversion of EBIT into free cash flow is also very pleasing. It should also be noted that Laboratory Corporation of America Holdings is in the healthcare business, which is often seen as quite defensive. Zooming out, Laboratory Corporation of America Holdings appears to be using debt quite sensibly; and that gets the green light from us. Although debt carries risks, when used wisely, it can also generate a higher return on equity. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. To this end, you should be aware of the 1 warning sign we spotted with Laboratory Corporation of America Holdings.

In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.