Here's Why Palla Pharma (ASX:PAL) Can Afford Some Debt

Simply Wall St
October 24, 2021
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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 note that Palla Pharma Limited (ASX:PAL) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Palla Pharma

How Much Debt Does Palla Pharma Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 Palla Pharma had AU$15.0m of debt, an increase on AU$12.8m, over one year. On the flip side, it has AU$897.3k in cash leading to net debt of about AU$14.1m.

ASX:PAL Debt to Equity History October 24th 2021

How Healthy Is Palla Pharma's Balance Sheet?

The latest balance sheet data shows that Palla Pharma had liabilities of AU$28.1m due within a year, and liabilities of AU$1.71m falling due after that. Offsetting these obligations, it had cash of AU$897.3k as well as receivables valued at AU$3.58m due within 12 months. So it has liabilities totalling AU$25.3m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Palla Pharma is worth AU$55.1m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. 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 Palla Pharma 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.

Over 12 months, Palla Pharma made a loss at the EBIT level, and saw its revenue drop to AU$17m, which is a fall of 58%. To be frank that doesn't bode well.

Caveat Emptor

Not only did Palla Pharma's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Its EBIT loss was a whopping AU$35m. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. However, it doesn't help that it burned through AU$23m of cash over the last year. So in short it's a really risky stock. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 4 warning signs for Palla Pharma (1 is potentially serious!) that you should be aware of before investing here.

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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