Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 note that Solventum Corporation (NYSE:SOLV) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Solventum's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Solventum had US$8.30b of debt, an increase on US$95.0m, over one year. However, because it has a cash reserve of US$996.0m, its net debt is less, at about US$7.31b.

A Look At Solventum's Liabilities

The latest balance sheet data shows that Solventum had liabilities of US$1.85b due within a year, and liabilities of US$9.01b falling due after that. Offsetting these obligations, it had cash of US$996.0m as well as receivables valued at US$1.22b due within 12 months. So it has liabilities totalling US$8.64b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of US$9.43b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Solventum's net debt is 3.2 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 43.7 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Solventum grew its EBIT by 5.7% in the last year. That's far from incredible but it is a good thing, when it comes to paying off 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 Solventum 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Solventum generated free cash flow amounting to a very robust 95% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Solventum's interest cover was a real positive on this analysis, as was its conversion of EBIT to free cash flow. On the other hand, its level of total liabilities makes us a little less comfortable about its debt. We would also note that Medical Equipment industry companies like Solventum commonly do use debt without problems. When we consider all the elements mentioned above, it seems to us that Solventum is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Solventum is showing 2 warning signs in our investment analysis , and 1 of those is a bit unpleasant...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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