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 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. Importantly, Costco Wholesale Corporation (NASDAQ:COST) does carry debt. But the real question is whether this debt is making the company risky.
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Costco Wholesale Carry?
The image below, which you can click on for greater detail, shows that Costco Wholesale had debt of US$6.10b at the end of May 2019, a reduction from US$6.49b over a year. But it also has US$8.17b in cash to offset that, meaning it has US$2.07b net cash.
How Healthy Is Costco Wholesale's Balance Sheet?
The latest balance sheet data shows that Costco Wholesale had liabilities of US$22.8b due within a year, and liabilities of US$6.10b falling due after that. Offsetting this, it had US$8.17b in cash and US$1.70b in receivables that were due within 12 months. So it has liabilities totalling US$19.1b more than its cash and near-term receivables, combined.
Since publicly traded Costco Wholesale shares are worth a very impressive total of US$119.3b, it seems unlikely that this level of liabilities would be a major threat. 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!
Fortunately, Costco Wholesale grew its EBIT by 5.3% in the last year, making that debt load look even more manageable. 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 Costco Wholesale can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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. Over the most recent three years, Costco Wholesale recorded free cash flow worth 63% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While Costco Wholesale does have more liabilities than liquid assets, it also has net cash of US$2.1b. So we don't have any problem with Costco Wholesale's use of debt. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Costco Wholesale insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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