David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We note that Coles Group Limited (ASX:COL) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Coles Group's Net Debt?
The image below, which you can click on for greater detail, shows that Coles Group had debt of AU$1.04b at the end of January 2022, a reduction from AU$1.14b over a year. But it also has AU$1.10b in cash to offset that, meaning it has AU$54.0m net cash.
How Healthy Is Coles Group's Balance Sheet?
According to the last reported balance sheet, Coles Group had liabilities of AU$6.35b due within 12 months, and liabilities of AU$9.24b due beyond 12 months. Offsetting this, it had AU$1.10b in cash and AU$336.0m in receivables that were due within 12 months. So it has liabilities totalling AU$14.1b more than its cash and near-term receivables, combined.
This deficit isn't so bad because Coles Group is worth a massive AU$23.7b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. While it does have liabilities worth noting, Coles Group also has more cash than debt, so we're pretty confident it can manage its debt safely.
Notably Coles Group's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish 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 Coles Group 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Coles Group 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 last three years, Coles Group recorded free cash flow worth a fulsome 93% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
Although Coles Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$54.0m. The cherry on top was that in converted 93% of that EBIT to free cash flow, bringing in AU$1.6b. So we don't have any problem with Coles Group's use of 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. To that end, you should be aware of the 1 warning sign we've spotted with Coles Group .
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.
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