Does Cochlear (ASX:COH) Have A Healthy Balance Sheet?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Cochlear Limited (ASX:COH) does carry debt. But should shareholders be worried about its use of debt?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Cochlear

What Is Cochlear's Net Debt?

As you can see below, at the end of June 2020, Cochlear had AU$473.0m of debt, up from AU$181.6m a year ago. Click the image for more detail. But it also has AU$930.0m in cash to offset that, meaning it has AU$457.0m net cash.

A Look At Cochlear's Liabilities

Zooming in on the latest balance sheet data, we can see that Cochlear had liabilities of AU$817.5m due within 12 months and liabilities of AU$356.7m due beyond that. Offsetting these obligations, it had cash of AU$930.0m as well as receivables valued at AU$304.9m due within 12 months. So it can boast AU$60.7m more liquid assets than total liabilities.

This state of affairs indicates that Cochlear's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the AU$15.4b company is struggling for cash, we still think it's worth monitoring its balance sheet. Succinctly put, Cochlear boasts net cash, so it's fair to say it does not have a heavy debt load!

The modesty of its debt load may become crucial for Cochlear if management cannot prevent a repeat of the 37% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Cochlear 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 company can only pay off debt with cold hard cash, not accounting profits. Cochlear 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. In the last three years, Cochlear created free cash flow amounting to 11% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Cochlear has net cash of AU$457.0m, as well as more liquid assets than liabilities. So we are not troubled with Cochlear's debt use. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Cochlear , and understanding them should be part of your investment process.

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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