These 4 Measures Indicate That Codan (ASX:CDA) Is Using Debt Reasonably Well

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 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. We can see that Codan Limited (ASX:CDA) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Codan

How Much Debt Does Codan Carry?

As you can see below, at the end of June 2024, Codan had AU$95.1m of debt, up from AU$75.4m a year ago. Click the image for more detail. However, it also had AU$19.7m in cash, and so its net debt is AU$75.4m.

A Look At Codan's Liabilities

We can see from the most recent balance sheet that Codan had liabilities of AU$155.4m falling due within a year, and liabilities of AU$166.4m due beyond that. Offsetting this, it had AU$19.7m in cash and AU$116.3m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$185.8m.

Since publicly traded Codan shares are worth a total of AU$3.01b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

Codan's net debt is only 0.62 times its EBITDA. And its EBIT easily covers its interest expense, being 12.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Another good sign is that Codan has been able to increase its EBIT by 25% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Codan 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Codan recorded free cash flow of 30% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that Codan's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. When we consider the range of factors above, it looks like Codan is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Codan insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.