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 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 Zoetis Inc. (NYSE:ZTS) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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.

See our latest analysis for Zoetis

What Is Zoetis's Net Debt?

The chart below, which you can click on for greater detail, shows that Zoetis had US$6.59b in debt in September 2024; about the same as the year before. On the flip side, it has US$1.71b in cash leading to net debt of about US$4.88b.

A Look At Zoetis' Liabilities

Zooming in on the latest balance sheet data, we can see that Zoetis had liabilities of US$1.70b due within 12 months and liabilities of US$7.42b due beyond that. Offsetting these obligations, it had cash of US$1.71b as well as receivables valued at US$1.41b due within 12 months. So it has liabilities totalling US$6.00b more than its cash and near-term receivables, combined.

Given Zoetis has a humongous market capitalization of US$79.3b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). 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).

Zoetis has a low net debt to EBITDA ratio of only 1.3. And its EBIT easily covers its interest expense, being 26.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Zoetis grew its EBIT by 9.2% in the last year, making that debt load look even more manageable. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Zoetis can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Zoetis produced sturdy free cash flow equating to 55% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Zoetis's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And we also thought its net debt to EBITDA was a positive. Taking all this data into account, it seems to us that Zoetis takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. To that end, you should be aware of the 1 warning sign we've spotted with Zoetis .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.