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Johnson & Johnson (NYSE:JNJ) Seems To Use Debt Quite Sensibly

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.' 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. We can see that Johnson & Johnson (NYSE:JNJ) does use debt in its business. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Johnson & Johnson

What Is Johnson & Johnson's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of April 2023 Johnson & Johnson had US$52.9b of debt, an increase on US$33.1b, over one year. However, because it has a cash reserve of US$24.6b, its net debt is less, at about US$28.3b.

debt-equity-history-analysis
debt-equity-history-analysis

A Look At Johnson & Johnson's Liabilities

We can see from the most recent balance sheet that Johnson & Johnson had liabilities of US$60.4b falling due within a year, and liabilities of US$64.7b due beyond that. Offsetting this, it had US$24.6b in cash and US$16.4b in receivables that were due within 12 months. So its liabilities total US$84.1b more than the combination of its cash and short-term receivables.

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Of course, Johnson & Johnson has a titanic market capitalization of US$431.8b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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).

Johnson & Johnson has net debt of just 0.85 times EBITDA, suggesting it could ramp leverage without breaking a sweat. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. Fortunately, Johnson & Johnson grew its EBIT by 3.9% in the last year, making that debt load look even more manageable. 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 Johnson & Johnson'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 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. Over the most recent three years, Johnson & Johnson recorded free cash flow worth 79% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, Johnson & Johnson's impressive interest cover implies it has the upper hand on its debt. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Zooming out, Johnson & Johnson seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. 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. These risks can be hard to spot. Every company has them, and we've spotted 5 warning signs for Johnson & Johnson you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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

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.

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