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 can see that Abbott Laboratories (NYSE:ABT) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
You can click the graphic below for the historical numbers, but it shows that Abbott Laboratories had US$15.0b of debt in September 2024, down from US$15.7b, one year before. However, it does have US$7.79b in cash offsetting this, leading to net debt of about US$7.26b.
How Strong Is Abbott Laboratories' Balance Sheet?
The latest balance sheet data shows that Abbott Laboratories had liabilities of US$14.9b due within a year, and liabilities of US$19.4b falling due after that. Offsetting this, it had US$7.79b in cash and US$7.05b in receivables that were due within 12 months. So its liabilities total US$19.5b more than the combination of its cash and short-term receivables.
Of course, Abbott Laboratories has a titanic market capitalization of US$196.8b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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).
Abbott Laboratories's net debt is only 0.67 times its EBITDA. And its EBIT easily covers its interest expense, being 31.7 times the size. So we're pretty relaxed about its super-conservative use of debt. And we also note warmly that Abbott Laboratories grew its EBIT by 11% last year, making its debt load easier to handle. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Abbott Laboratories'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.
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. During the last three years, Abbott Laboratories produced sturdy free cash flow equating to 79% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Our View
The good news is that Abbott Laboratories's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! It's also worth noting that Abbott Laboratories is in the Medical Equipment industry, which is often considered to be quite defensive. Considering this range of factors, it seems to us that Abbott Laboratories is quite prudent with its debt, and the risks seem well managed. So we're not worried about the use of a little leverage on the balance sheet. We'd be very excited to see if Abbott Laboratories insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt100% free, right now.
Have feedback on this article? Concerned about the content?Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.