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.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that CVS Health Corporation (NYSE:CVS) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. 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. 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 step when considering a company’s debt levels is to consider its cash and debt together.
View our latest analysis for CVS Health
How Much Debt Does CVS Health Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2023 CVS Health had US$62.3b of debt, an increase on US$53.4b, over one year. On the flip side, it has US$16.9b in cash leading to net debt of about US$45.4b.
How Strong Is CVS Health’s Balance Sheet?
According to the last reported balance sheet, CVS Health had liabilities of US$79.2b due within 12 months, and liabilities of US$97.9b due beyond 12 months. On the other hand, it had cash of US$16.9b and US$29.5b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$130.6b.
This deficit casts a shadow over the US$85.4b company, like a colossus towering over mere mortals. So we’d watch its balance sheet closely, without a doubt. After all, CVS Health would likely require a major re-capitalisation if it had to pay its creditors today.
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.
CVS Health’s net debt to EBITDA ratio of about 2.5 suggests only moderate use of debt. And its commanding EBIT of 11.2 times its interest expense, implies the debt load is as light as a peacock feather. Sadly, CVS Health’s EBIT actually dropped 6.7% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine CVS Health’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, CVS Health actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
While CVS Health’s level of total liabilities has us nervous. For example, its conversion of EBIT to free cash flow and interest cover give us some confidence in its ability to manage its debt. It’s also worth noting that CVS Health is in the Healthcare industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think CVS Health’s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. For example – CVS Health has 5 warning signs we think you should be aware of.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
What are the risks and opportunities for CVS Health?
Trading at 64% below our estimate of its fair value
Earnings are forecast to grow 24.35% per year
Significant insider selling over the past 3 months
Profit margins (0.8%) are lower than last year (2.7%)
Large one-off items impacting financial results
View all Risks and Rewards
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.