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. We note that Dermapharm Holding SE (ETR:DMP) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Dermapharm Holding Carry?
You can click the graphic below for the historical numbers, but it shows that as of March 2020 Dermapharm Holding had €544.8m of debt, an increase on €495.0m, over one year. However, because it has a cash reserve of €143.4m, its net debt is less, at about €401.5m.
How Strong Is Dermapharm Holding’s Balance Sheet?
According to the last reported balance sheet, Dermapharm Holding had liabilities of €118.2m due within 12 months, and liabilities of €658.5m due beyond 12 months. Offsetting this, it had €143.4m in cash and €60.5m in receivables that were due within 12 months. So its liabilities total €572.9m more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Dermapharm Holding is worth €2.38b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Dermapharm Holding’s net debt is 2.8 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 15.8 is very high, suggesting that the interest expense on the debt is currently quite low. Also relevant is that Dermapharm Holding has grown its EBIT by a very respectable 22% in the last year, thus enhancing its ability to pay down 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 Dermapharm Holding 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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Dermapharm Holding recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Dermapharm Holding’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But truth be told we feel its net debt to EBITDA does undermine this impression a bit. Taking all this data into account, it seems to us that Dermapharm Holding takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider risks, for instance. Every company has them, and we’ve spotted 2 warning signs for Dermapharm Holding you should know about.
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.
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