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.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Catalent, Inc. (NYSE:CTLT) does carry debt. But the real question is whether this debt is making the company risky.
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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
View our latest analysis for Catalent
What Is Catalent’s Debt?
The chart below, which you can click on for greater detail, shows that Catalent had US$3.96b in debt in September 2022; about the same as the year before. However, it also had US$345.0m in cash, and so its net debt is US$3.62b.
A Look At Catalent’s Liabilities
The latest balance sheet data shows that Catalent had liabilities of US$943.0m due within a year, and liabilities of US$4.56b falling due after that. Offsetting this, it had US$345.0m in cash and US$1.41b in receivables that were due within 12 months. So it has liabilities totalling US$3.75b more than its cash and near-term receivables, combined.
Catalent has a market capitalization of US$9.64b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
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).
Catalent has a debt to EBITDA ratio of 3.3 and its EBIT covered its interest expense 5.5 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Notably Catalent’s EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. 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 Catalent’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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Catalent burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Mulling over Catalent’s attempt at converting EBIT to free cash flow, we’re certainly not enthusiastic. Having said that, its ability to cover its interest expense with its EBIT isn’t such a worry. Once we consider all the factors above, together, it seems to us that Catalent’s debt is making it a bit risky. Some people like that sort of risk, but we’re mindful of the potential pitfalls, so we’d probably prefer it carry less debt. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we’ve spotted 3 warning signs for Catalent (of which 1 is concerning!) you should know about.
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 Catalent?
Catalent, Inc., together with its subsidiaries, develops and manufactures solutions for drugs, protein-based biologics, cell and gene therapies, and consumer health products worldwide.
Trading at 2.3% below our estimate of its fair value
Earnings are forecast to grow 14.68% per year
Debt is not well covered by operating cash flow
Significant insider selling over the past 3 months
Profit margins (8.7%) are lower than last year (13%)
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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.