Yahoo Finance Here's Why Cochlear (ASX:COH) Can Manage Its Debt Responsibly
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. Importantly, Cochlear Limited (ASX:COH) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for Cochlear
What Is Cochlear's Debt?
You can click the graphic below for the historical numbers, but it shows that Cochlear had AU$110.8m of debt in December 2020, down from AU$233.7m, one year before. But it also has AU$612.7m in cash to offset that, meaning it has AU$501.9m net cash.
How Healthy Is Cochlear's Balance Sheet?
The latest balance sheet data shows that Cochlear had liabilities of AU$369.6m due within a year, and liabilities of AU$349.4m falling due after that. Offsetting these obligations, it had cash of AU$612.7m as well as receivables valued at AU$327.5m due within 12 months. So it can boast AU$221.2m more liquid assets than total liabilities.
Having regard to Cochlear's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the AU$13.9b company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that Cochlear has more cash than debt is arguably a good indication that it can manage its debt safely.
In fact Cochlear's saving grace is its low debt levels, because its EBIT has tanked 37% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 Cochlear 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. Cochlear may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Cochlear reported free cash flow worth 7.9% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Summing up
While it is always sensible to investigate a company's debt, in this case Cochlear has AU$501.9m in net cash and a decent-looking balance sheet. So we are not troubled with Cochlear's debt use. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for Cochlear that you should be aware of before investing here.
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.
This article by Simply Wall St is general in nature. 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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