Here's Why Coloplast (CPH:COLO B) Can Manage Its Debt Responsibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Coloplast A/S (CPH:COLO B) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. 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 Coloplast

What Is Coloplast's Debt?

As you can see below, at the end of December 2020, Coloplast had kr.4.02b of debt, up from kr.2.99b a year ago. Click the image for more detail. However, it also had kr.692.0m in cash, and so its net debt is kr.3.33b.

How Strong Is Coloplast's Balance Sheet?

The latest balance sheet data shows that Coloplast had liabilities of kr.7.78b due within a year, and liabilities of kr.1.37b falling due after that. Offsetting these obligations, it had cash of kr.692.0m as well as receivables valued at kr.3.55b due within 12 months. So its liabilities total kr.4.92b more than the combination of its cash and short-term receivables.

Since publicly traded Coloplast shares are worth a very impressive total of kr.203.1b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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.

Coloplast has a low net debt to EBITDA ratio of only 0.51. And its EBIT easily covers its interest expense, being 269 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The good news is that Coloplast has increased its EBIT by 3.1% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Coloplast'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, 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 61% 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

The good news is that Coloplast's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. We would also note that Medical Equipment industry companies like Coloplast commonly do use debt without problems. Zooming out, Coloplast seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. 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 2 warning signs for Coloplast you should be aware of.

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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