Here's Why Cochlear (ASX:COH) Can Manage Its Debt Responsibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Cochlear Limited (ASX:COH) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Cochlear

What Is Cochlear's Debt?

You can click the graphic below for the historical numbers, but it shows that Cochlear had AU$42.6m of debt in June 2022, down from AU$45.0m, one year before. But on the other hand it also has AU$629.3m in cash, leading to a AU$586.7m net cash position.

A Look At Cochlear's Liabilities

The latest balance sheet data shows that Cochlear had liabilities of AU$527.6m due within a year, and liabilities of AU$251.8m falling due after that. Offsetting these obligations, it had cash of AU$629.3m as well as receivables valued at AU$390.4m due within 12 months. So it actually has AU$240.3m 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$14.5b 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!

And we also note warmly that Cochlear grew its EBIT by 12% last year, making its debt load easier to handle. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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's free cash flow amounted to 22% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case Cochlear has AU$586.7m in net cash and a decent-looking balance sheet. On top of that, it increased its EBIT by 12% in the last twelve months. So we don't have any problem with Cochlear's use of debt. Over time, share prices tend to follow earnings per share, so if you're interested in Cochlear, you may well want to click here to check an interactive graph of its earnings per share history.

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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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.