Sopharma AD (BUL:3JR) Has A Somewhat Strained Balance Sheet

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Sopharma AD (BUL:3JR) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Sopharma AD

How Much Debt Does Sopharma AD Carry?

The image below, which you can click on for greater detail, shows that Sopharma AD had debt of лв366.1m at the end of September 2020, a reduction from лв392.3m over a year. However, it does have лв22.0m in cash offsetting this, leading to net debt of about лв344.2m.

How Healthy Is Sopharma AD's Balance Sheet?

We can see from the most recent balance sheet that Sopharma AD had liabilities of лв512.8m falling due within a year, and liabilities of лв94.4m due beyond that. On the other hand, it had cash of лв22.0m and лв334.7m worth of receivables due within a year. So it has liabilities totalling лв250.5m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of лв397.4m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Sopharma AD's debt is 3.7 times its EBITDA, and its EBIT cover its interest expense 3.8 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. On a slightly more positive note, Sopharma AD grew its EBIT at 13% over the last year, further increasing its ability to manage 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 Sopharma AD'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Sopharma AD saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Mulling over Sopharma AD's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Sopharma AD's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 4 warning signs we've spotted with Sopharma AD (including 3 which can't be ignored) .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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