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Here's Why Cochlear (ASX:COH) Can Manage Its Debt Responsibly

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. We can see that Cochlear Limited (ASX:COH) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Cochlear

What Is Cochlear's Debt?

The image below, which you can click on for greater detail, shows that at June 2019 Cochlear had debt of AU$181.6m, up from AU$147.7m in one year. However, it also had AU$78.6m in cash, and so its net debt is AU$103.0m.

ASX:COH Historical Debt, September 17th 2019
ASX:COH Historical Debt, September 17th 2019

How Healthy Is Cochlear's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Cochlear had liabilities of AU$359.5m due within 12 months and liabilities of AU$293.8m due beyond that. Offsetting this, it had AU$78.6m in cash and AU$331.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$242.8m.

Having regard to Cochlear's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the AU$12.2b company is short on cash, but still worth keeping an eye on the balance sheet. Carrying virtually no net debt, Cochlear has a very light debt load indeed.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Cochlear's net debt is only 0.27 times its EBITDA. And its EBIT covers its interest expense a whopping 78.4 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Cochlear grew its EBIT by 2.2% in the last year, making that debt load look even more manageable. 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 Cochlear'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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Cochlear produced sturdy free cash flow equating to 57% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, Cochlear's impressive interest cover implies it has the upper hand on its debt. And we also thought its net debt to EBITDA was a positive. It's also worth noting that Cochlear is in the Medical Equipment industry, which is often considered to be quite defensive. Looking at the bigger picture, we think Cochlear's use of debt seems quite reasonable and we're not concerned about it. 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 Cochlear, 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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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.

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