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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Merit Medical Systems, Inc. (NASDAQ:MMSI) does carry debt. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is Merit Medical Systems's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Merit Medical Systems had debt of US$800.1m, up from US$197.7m in one year. On the flip side, it has US$583.1m in cash leading to net debt of about US$217.1m.

How Healthy Is Merit Medical Systems' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Merit Medical Systems had liabilities of US$183.3m due within 12 months and liabilities of US$902.8m due beyond that. On the other hand, it had cash of US$583.1m and US$192.1m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$311.0m.

Of course, Merit Medical Systems has a market capitalization of US$4.67b, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Merit Medical Systems has a low net debt to EBITDA ratio of only 0.95. And its EBIT easily covers its interest expense, being 11.4 times the size. So we're pretty relaxed about its super-conservative use of debt. Another good sign is that Merit Medical Systems has been able to increase its EBIT by 25% in twelve months, making it easier to pay down 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 Merit Medical Systems'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Merit Medical Systems generated free cash flow amounting to a very robust 82% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Happily, Merit Medical Systems's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And that's just the beginning of the good news since its interest cover is also very heartening. We would also note that Medical Equipment industry companies like Merit Medical Systems commonly do use debt without problems. We think Merit Medical Systems is no more beholden to its lenders, than the birds are to birdwatchers. To our minds it has a healthy happy balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Merit Medical Systems is showing 1 warning sign in our investment analysis , you should know about...

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.