Coloplast (CPH:COLO B) Has A Rock Solid Balance Sheet

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Coloplast A/S (CPH:COLO B) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Coloplast

What Is Coloplast's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Coloplast had debt of kr.1.11b, up from kr.1.07b in one year. However, it does have kr.585.0m in cash offsetting this, leading to net debt of about kr.526.0m.

How Strong Is Coloplast's Balance Sheet?

We can see from the most recent balance sheet that Coloplast had liabilities of kr.4.98b falling due within a year, and liabilities of kr.1.11b due beyond that. Offsetting this, it had kr.585.0m in cash and kr.3.51b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr.1.99b.

Having regard to Coloplast's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the kr.195.3b company is struggling for cash, we still think it's worth monitoring its balance sheet. But either way, Coloplast has virtually no net debt, so it's fair to say it does not have a heavy debt load!

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

With debt at a measly 0.082 times EBITDA and EBIT covering interest a whopping 266 times, it's clear that Coloplast is not a desperate borrower. So relative to past earnings, the debt load seems trivial. Fortunately, Coloplast grew its EBIT by 4.8% in the last year, making that debt load look even more manageable. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Coloplast 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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Coloplast produced sturdy free cash flow equating to 68% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, Coloplast's impressive interest cover implies it has the upper hand on its debt. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. It's also worth noting that Coloplast is in the Medical Equipment industry, which is often considered to be quite defensive. Zooming out, Coloplast seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. Take risks, for example - Coloplast has 1 warning sign we think you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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