These 4 Measures Indicate That Compumedics (ASX:CMP) Is Using Debt Extensively

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. We can see that Compumedics Limited (ASX:CMP) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

View our latest analysis for Compumedics

What Is Compumedics's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Compumedics had debt of AU$3.69m, up from AU$1.76m in one year. However, its balance sheet shows it holds AU$5.56m in cash, so it actually has AU$1.87m net cash.

How Healthy Is Compumedics' Balance Sheet?

According to the last reported balance sheet, Compumedics had liabilities of AU$13.0m due within 12 months, and liabilities of AU$744.0k due beyond 12 months. Offsetting these obligations, it had cash of AU$5.56m as well as receivables valued at AU$13.3m 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. Succinctly put, Compumedics boasts net cash, so it's fair to say it does not have a heavy debt load!

Shareholders should be aware that Compumedics's EBIT was down 81% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 Compumedics 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Compumedics 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, Compumedics reported free cash flow worth 12% of its EBIT, which is really quite low. 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. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Compumedics you should be aware of.

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.

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