Stock Analysis

Does Coty (NYSE:COTY) Have A Healthy Balance Sheet?

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NYSE:COTY
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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.' 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. As with many other companies Coty Inc. (NYSE:COTY) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Coty

What Is Coty's Debt?

You can click the graphic below for the historical numbers, but it shows that Coty had US$4.90b of debt in December 2021, down from US$5.34b, one year before. However, it does have US$523.4m in cash offsetting this, leading to net debt of about US$4.38b.

debt-equity-history-analysis
NYSE:COTY Debt to Equity History April 6th 2022

How Strong Is Coty's Balance Sheet?

According to the last reported balance sheet, Coty had liabilities of US$2.90b due within 12 months, and liabilities of US$6.64b due beyond 12 months. Offsetting these obligations, it had cash of US$523.4m as well as receivables valued at US$691.2m due within 12 months. So it has liabilities totalling US$8.32b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of US$7.37b, we think shareholders really should watch Coty's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 1.1 times and a disturbingly high net debt to EBITDA ratio of 5.1 hit our confidence in Coty like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. One redeeming factor for Coty is that it turned last year's EBIT loss into a gain of US$302m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Coty 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Coty actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

To be frank both Coty's net debt to EBITDA and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Once we consider all the factors above, together, it seems to us that Coty's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 4 warning signs for Coty you should be aware of, and 2 of them can't be ignored.

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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