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.’ 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 should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. 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 Costco Wholesale’s Debt?
As you can see below, at the end of February 2021, Costco Wholesale had US$7.36b of debt, up from US$5.60b a year ago. Click the image for more detail. However, it does have US$9.25b in cash offsetting this, leading to net cash of US$1.90b.
A Look At Costco Wholesale’s Liabilities
Zooming in on the latest balance sheet data, we can see that Costco Wholesale had liabilities of US$26.6b due within 12 months and liabilities of US$12.2b due beyond that. On the other hand, it had cash of US$9.25b and US$1.93b worth of receivables due within a year. So its liabilities total US$27.6b more than the combination of its cash and short-term receivables.
Given Costco Wholesale has a humongous market capitalization of US$160.8b, it’s hard to believe these liabilities pose much threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Costco Wholesale boasts net cash, so it’s fair to say it does not have a heavy debt load!
On top of that, Costco Wholesale grew its EBIT by 32% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Costco Wholesale’s ability to maintain a healthy balance sheet going forward.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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. During the last three years, Costco Wholesale produced sturdy free cash flow equating to 79% 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$1.90b. And it impressed us with its EBIT growth of 32% over the last year. So we don’t think Costco Wholesale’s use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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.