Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Costco Wholesale Corporation (NASDAQ:COST) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.
How Much Debt Does Costco Wholesale Carry?
As you can see below, at the end of May 2020, Costco Wholesale had US$9.10b of debt, up from US$6.50b a year ago. Click the image for more detail. But it also has US$11.8b in cash to offset that, meaning it has US$2.68b net cash.
How Strong Is Costco Wholesale's Balance Sheet?
We can see from the most recent balance sheet that Costco Wholesale had liabilities of US$22.8b falling due within a year, and liabilities of US$11.8b due beyond that. Offsetting this, it had US$11.8b in cash and US$1.51b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$21.2b.
Of course, Costco Wholesale has a titanic market capitalization of US$150.1b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Costco Wholesale boasts net cash, so it's fair to say it does not have a heavy debt load!
And we also note warmly that Costco Wholesale grew its EBIT by 10% last year, making its debt load easier to handle. 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 Costco Wholesale's ability to maintain a healthy balance sheet going forward. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Costco Wholesale may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Costco Wholesale produced sturdy free cash flow equating to 68% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Although Costco Wholesale's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$2.68b. The cherry on top was that in converted 68% of that EBIT to free cash flow, bringing in US$3.9b. So we don't think Costco Wholesale's use of debt is risky. 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. For instance, we've identified 2 warning signs for Costco Wholesale that you should be aware of.
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.
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. 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.
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