Is Cogstate (ASX:CGS) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Cogstate Limited (ASX:CGS) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 Cogstate

What Is Cogstate's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Cogstate had US$2.88m of debt, an increase on US$861.4k, over one year. But it also has US$21.3m in cash to offset that, meaning it has US$18.5m net cash.

A Look At Cogstate's Liabilities

We can see from the most recent balance sheet that Cogstate had liabilities of US$18.7m falling due within a year, and liabilities of US$12.9m due beyond that. On the other hand, it had cash of US$21.3m and US$5.49m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.74m.

Of course, Cogstate has a market capitalization of US$122.9m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Cogstate boasts net cash, so it's fair to say it does not have a heavy debt load!

It was also good to see that despite losing money on the EBIT line last year, Cogstate turned things around in the last 12 months, delivering and EBIT of US$2.1m. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Cogstate will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Cogstate 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 year, Cogstate actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing up

We could understand if investors are concerned about Cogstate's liabilities, but we can be reassured by the fact it has has net cash of US$18.5m. The cherry on top was that in converted 538% of that EBIT to free cash flow, bringing in US$11m. So is Cogstate's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Cogstate that you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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