Here's Why Compumedics (ASX:CMP) Has A Meaningful Debt Burden

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We note that Compumedics Limited (ASX:CMP) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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.

View our latest analysis for Compumedics

What Is Compumedics's Net Debt?

As you can see below, at the end of December 2020, Compumedics had AU$3.69m of debt, up from AU$1.76m a year ago. Click the image for more detail. But it also has AU$5.56m in cash to offset that, meaning it has AU$1.87m net cash.

How Healthy Is Compumedics' Balance Sheet?

The latest balance sheet data shows that Compumedics had liabilities of AU$13.0m due within a year, and liabilities of AU$744.0k falling due after that. Offsetting this, it had AU$5.56m in cash and AU$13.3m in receivables that were due within 12 months. So it actually has AU$5.05m more liquid assets than total liabilities.

This surplus suggests that Compumedics has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Compumedics has more cash than debt is arguably a good indication that it can manage its debt safely.

Shareholders should be aware that Compumedics's EBIT was down 81% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Compumedics's ability to maintain a healthy balance sheet going forward. 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. 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 three years, Compumedics created free cash flow amounting to 12% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing up

While it is always sensible to investigate a company's debt, in this case Compumedics has AU$1.87m in net cash and a decent-looking balance sheet. So although we see some areas for improvement, we're not too worried about Compumedics's balance sheet. 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 Compumedics .

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.

When trading Compumedics or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.