Coles Group (ASX:COL) 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Coles Group Limited (ASX:COL) does carry debt. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Coles Group

How Much Debt Does Coles Group Carry?

As you can see below, Coles Group had AU$1.14b of debt at January 2021, down from AU$1.36b a year prior. But it also has AU$1.18b in cash to offset that, meaning it has AU$38.0m net cash.

How Strong Is Coles Group's Balance Sheet?

According to the last reported balance sheet, Coles Group had liabilities of AU$6.26b due within 12 months, and liabilities of AU$9.90b due beyond 12 months. On the other hand, it had cash of AU$1.18b and AU$415.0m worth of receivables due within a year. So its liabilities total AU$14.6b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its very significant market capitalization of AU$20.7b, so it does suggest shareholders should keep an eye on Coles Group's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. While it does have liabilities worth noting, Coles Group also has more cash than debt, so we're pretty confident it can manage its debt safely.

Importantly, Coles Group grew its EBIT by 30% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Coles Group 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Coles Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Coles Group generated free cash flow amounting to a very robust 99% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing up

Although Coles Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$38.0m. The cherry on top was that in converted 99% of that EBIT to free cash flow, bringing in AU$2.2b. So we don't have any problem with Coles Group's use of debt. 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. We've identified 2 warning signs with Coles Group , and understanding them should be part of your investment process.

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.

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