Public Companies

Avanos Medical (NYSE:AVNS) Takes On Some Risk With Its Use Of Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 can see that Avanos Medical, Inc. (NYSE:AVNS) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Avanos Medical's Net Debt?

The image below, which you can click on for greater detail, shows that Avanos Medical had debt of US$175.0m at the end of March 2021, a reduction from US$248.2m over a year. On the flip side, it has US$100.1m in cash leading to net debt of about US$74.9m.

debt-equity-history-analysisNYSE:AVNS Debt to Equity History July 30th 2021

How Strong Is Avanos Medical's Balance Sheet?

According to the last reported balance sheet, Avanos Medical had liabilities of US$154.6m due within 12 months, and liabilities of US$241.6m due beyond 12 months. On the other hand, it had cash of US$100.1m and US$164.3m worth of receivables due within a year. So it has liabilities totalling US$131.8m more than its cash and near-term receivables, combined.

Of course, Avanos Medical has a market capitalization of US$1.82b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). 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).

Avanos Medical has a very low debt to EBITDA ratio of 1.4 so it is strange to see weak interest coverage, with last year's EBIT being only 1.1 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. Shareholders should be aware that Avanos Medical's EBIT was down 43% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Avanos Medical can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last two years, Avanos Medical burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Avanos Medical's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. We should also note that Medical Equipment industry companies like Avanos Medical commonly do use debt without problems. Looking at the bigger picture, it seems clear to us that Avanos Medical's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Even though Avanos Medical lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

This article by Simply Wall St is general in nature. 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.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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