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.' 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 Quest Diagnostics Incorporated (NYSE:DGX) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Quest Diagnostics's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Quest Diagnostics had debt of US$4.71b, up from US$3.98b in one year. However, it also had US$474.0m in cash, and so its net debt is US$4.24b.

A Look At Quest Diagnostics' Liabilities

Zooming in on the latest balance sheet data, we can see that Quest Diagnostics had liabilities of US$2.30b due within 12 months and liabilities of US$5.11b due beyond that. Offsetting this, it had US$474.0m in cash and US$1.32b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$5.61b.

While this might seem like a lot, it is not so bad since Quest Diagnostics has a huge market capitalization of US$15.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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).

With a debt to EBITDA ratio of 2.4, Quest Diagnostics uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 8.3 times its interest expenses harmonizes with that theme. Notably Quest Diagnostics's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Quest Diagnostics can strengthen its balance sheet over time. 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Quest Diagnostics recorded free cash flow worth 69% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Quest Diagnostics's conversion of EBIT to free cash flow was a real positive on this analysis, as was its interest cover. Having said that, its net debt to EBITDA somewhat sensitizes us to potential future risks to the balance sheet. It's also worth noting that Quest Diagnostics is in the Healthcare industry, which is often considered to be quite defensive. Considering this range of data points, we think Quest Diagnostics is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for Quest Diagnostics that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com