Cochlear (ASX:COH) Has A Pretty Healthy Balance Sheet

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Cochlear Limited (ASX:COH) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 Cochlear

How Much Debt Does Cochlear Carry?

You can click the graphic below for the historical numbers, but it shows that Cochlear had AU$110.8m of debt in December 2020, down from AU$233.7m, one year before. But on the other hand it also has AU$612.7m in cash, leading to a AU$501.9m net cash position.

How Healthy Is Cochlear's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Cochlear had liabilities of AU$369.6m due within 12 months and liabilities of AU$349.4m due beyond that. Offsetting this, it had AU$612.7m in cash and AU$327.5m in receivables that were due within 12 months. So it actually has AU$221.2m more liquid assets than total liabilities.

Having regard to Cochlear's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the AU$16.1b company is struggling for cash, we still think it's worth monitoring its balance sheet. Simply put, the fact that Cochlear has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Cochlear's load is not too heavy, because its EBIT was down 37% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Cochlear 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 company can only pay off debt with cold hard cash, not accounting profits. While Cochlear 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, Cochlear created free cash flow amounting to 7.9% 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 it is always sensible to investigate a company's debt, in this case Cochlear has AU$501.9m in net cash and a decent-looking balance sheet. So we are not troubled with Cochlear's debt use. Even though Cochlear lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.

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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