These 4 Measures Indicate That Cochlear (ASX:COH) Is Using Debt Reasonably Well

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.' 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. As with many other companies Cochlear Limited (ASX:COH) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Cochlear

What Is Cochlear's Debt?

As you can see below, Cochlear had AU$110.8m of debt at December 2020, down from AU$233.7m a year prior. However, its balance sheet shows it holds AU$612.7m in cash, so it actually has AU$501.9m net cash.

How Healthy Is Cochlear's Balance Sheet?

The latest balance sheet data shows that Cochlear had liabilities of AU$369.6m due within a year, and liabilities of AU$349.4m falling due after that. Offsetting these obligations, it had cash of AU$612.7m as well as receivables valued at AU$327.5m due within 12 months. So it actually has AU$221.2m 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 it's very unlikely that the AU$13.3b company is short on cash, but still worth keeping an eye on the 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Cochlear's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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 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 we empathize with investors who find debt concerning, you should keep in mind that Cochlear has net cash of AU$501.9m, as well as more liquid assets than liabilities. So we are not troubled with Cochlear's debt use. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. 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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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.
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