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 Quest Diagnostics Incorporated (NYSE:DGX) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Quest Diagnostics Carry?

As you can see below, Quest Diagnostics had US$4.41b of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$271.0m, its net debt is less, at about US$4.13b.

How Strong Is Quest Diagnostics' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Quest Diagnostics had liabilities of US$2.01b due within 12 months and liabilities of US$5.13b due beyond that. Offsetting these obligations, it had cash of US$271.0m as well as receivables valued at US$1.32b due within 12 months. So it has liabilities totalling US$5.56b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Quest Diagnostics is worth a massive US$17.2b, and thus could probably raise enough capital to shore up 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a debt to EBITDA ratio of 2.3, Quest Diagnostics uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 8.0 times its interest expenses harmonizes with that theme. We saw Quest Diagnostics grow its EBIT by 2.5% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Quest Diagnostics'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, Quest Diagnostics produced sturdy free cash flow equating to 69% 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 Quest Diagnostics's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And we also thought its interest cover was a positive. It's also worth noting that Quest Diagnostics is in the Healthcare industry, which is often considered to be quite defensive. All these things considered, it appears that Quest Diagnostics can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for Quest Diagnostics that you should be aware of.

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.

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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.