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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. Importantly, The Cooper Companies, Inc. (NYSE:COO) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Cooper Companies’s Debt?
You can click the graphic below for the historical numbers, but it shows that Cooper Companies had US$1.93b of debt in April 2019, down from US$2.48b, one year before However, it also had US$104.6m in cash, and so its net debt is US$1.82b.
How Healthy Is Cooper Companies’s Balance Sheet?
We can see from the most recent balance sheet that Cooper Companies had liabilities of US$940.9m falling due within a year, and liabilities of US$1.72b due beyond that. Offsetting these obligations, it had cash of US$104.6m as well as receivables valued at US$396.2m due within 12 months. So it has liabilities totalling US$2.16b more than its cash and near-term receivables, combined.
Since publicly traded Cooper Companies shares are worth a very impressive total of US$16.5b, 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. Since Cooper Companies does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Cooper Companies’s net debt is sitting at a very reasonable 2.31 times its EBITDA, while its EBIT covered its interest expense just 6.20 times last year. While these numbers do not alarm us, it’s worth noting that the cost of the company’s debt is having a real impact. Cooper Companies grew its EBIT by 5.1% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. 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 Cooper Companies 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Cooper Companies created free cash flow amounting to 19% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks some a little paranoia about is ability to extinguish debt.
Based on what we’ve seen Cooper Companies is not finding it easy conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. There’s no doubt that it has an adequate capacity to handle its total liabilities. We would also note that Medical Equipment industry companies like Cooper Companies commonly do use debt without problems. When we consider all the factors mentioned above, we do feel a bit cautious about Cooper Companies’s use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. We’d be motivated to research the stock further if we found out that Cooper Companies insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.