Compumedics (ASX:CMP) Seems To Use Debt Quite Sensibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Compumedics Limited (ASX:CMP) makes use of debt. But is this debt a concern to shareholders?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Our analysis indicates that CMP is potentially overvalued!

What Is Compumedics's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Compumedics had AU$6.38m of debt, an increase on AU$4.99m, over one year. However, it does have AU$7.29m in cash offsetting this, leading to net cash of AU$910.0k.

How Healthy Is Compumedics' Balance Sheet?

We can see from the most recent balance sheet that Compumedics had liabilities of AU$17.5m falling due within a year, and liabilities of AU$578.0k due beyond that. On the other hand, it had cash of AU$7.29m and AU$16.5m worth of receivables due within a year. So it actually has AU$5.72m more liquid assets than total liabilities.

This short term liquidity is a sign that Compumedics could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Compumedics boasts net cash, so it's fair to say it does not have a heavy debt load!

Compumedics grew its EBIT by 3.1% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Compumedics 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 company can only pay off debt with cold hard cash, not accounting profits. While Compumedics 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. In the last two years, Compumedics created free cash flow amounting to 3.7% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Compumedics has net cash of AU$910.0k, as well as more liquid assets than liabilities. And it also grew its EBIT by 3.1% over the last year. So we are not troubled with Compumedics's debt use. 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. For instance, we've identified 3 warning signs for Compumedics (1 is potentially serious) you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.