We Think Computershare (ASX:CPU) Is Taking Some Risk With Its Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Computershare Limited (ASX:CPU) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Computershare

What Is Computershare's Net Debt?

The image below, which you can click on for greater detail, shows that Computershare had debt of US$1.71b at the end of June 2021, a reduction from US$2.03b over a year. However, because it has a cash reserve of US$825.4m, its net debt is less, at about US$884.6m.

A Look At Computershare's Liabilities

According to the last reported balance sheet, Computershare had liabilities of US$995.7m due within 12 months, and liabilities of US$1.98b due beyond 12 months. Offsetting these obligations, it had cash of US$825.4m as well as receivables valued at US$430.5m due within 12 months. So its liabilities total US$1.72b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Computershare has a market capitalization of US$7.15b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Computershare's net debt is sitting at a very reasonable 1.6 times its EBITDA, while its EBIT covered its interest expense just 5.9 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Unfortunately, Computershare's EBIT flopped 17% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Computershare 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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Computershare produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Computershare's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to to convert EBIT to free cash flow isn't too shabby at all. We think that Computershare's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 4 warning signs for Computershare you should be aware of, and 1 of them is concerning.

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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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.
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