Compass Group (LON:CPG) Has A Pretty Healthy Balance Sheet

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that Compass Group PLC (LON:CPG) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Compass Group

What Is Compass Group's Debt?

As you can see below, Compass Group had UK£3.20b of debt at March 2022, down from UK£3.59b a year prior. However, it does have UK£1.48b in cash offsetting this, leading to net debt of about UK£1.72b.

A Look At Compass Group's Liabilities

We can see from the most recent balance sheet that Compass Group had liabilities of UK£5.63b falling due within a year, and liabilities of UK£4.22b due beyond that. On the other hand, it had cash of UK£1.48b and UK£3.06b worth of receivables due within a year. So it has liabilities totalling UK£5.31b more than its cash and near-term receivables, combined.

Of course, Compass Group has a titanic market capitalization of UK£33.1b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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.

Compass Group's net debt is only 1.2 times its EBITDA. And its EBIT easily covers its interest expense, being 11.6 times the size. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Compass Group grew its EBIT by 4,450% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Compass Group'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Compass Group recorded free cash flow worth 61% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, Compass Group's impressive EBIT growth rate implies it has the upper hand on its debt. And the good news does not stop there, as its interest cover also supports that impression! Zooming out, Compass Group seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. Over time, share prices tend to follow earnings per share, so if you're interested in Compass Group, you may well want to click here to check an interactive graph of its earnings per share history.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.