Varex Imaging (NASDAQ:VREX) Seems To Use Debt Quite Sensibly

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.' 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, Varex Imaging Corporation (NASDAQ:VREX) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Varex Imaging's Debt?

You can click the graphic below for the historical numbers, but it shows that Varex Imaging had US$412.6m of debt in July 2022, down from US$462.7m, one year before. However, it does have US$99.6m in cash offsetting this, leading to net debt of about US$313.0m.

How Strong Is Varex Imaging's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Varex Imaging had liabilities of US$172.3m due within 12 months and liabilities of US$463.0m due beyond that. Offsetting these obligations, it had cash of US$99.6m as well as receivables valued at US$157.5m due within 12 months. So it has liabilities totalling US$378.2m more than its cash and near-term receivables, combined.

Varex Imaging has a market capitalization of US$903.0m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Varex Imaging has a quite reasonable net debt to EBITDA multiple of 2.5, its interest cover seems weak, at 2.2. This does suggest the company is paying fairly high interest rates. In any case, it's safe to say the company has meaningful debt. Notably, Varex Imaging's EBIT launched higher than Elon Musk, gaining a whopping 215% on last year. 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 Varex Imaging's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Varex Imaging recorded free cash flow of 49% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

On our analysis Varex Imaging's EBIT growth rate should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. In particular, interest cover gives us cold feet. We would also note that Medical Equipment industry companies like Varex Imaging commonly do use debt without problems. When we consider all the elements mentioned above, it seems to us that Varex Imaging 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. For example - Varex Imaging has 1 warning sign we think you should be aware of.

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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