Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Tchaikapharma High Quality Medicines AD (BUL:7TH) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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, 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.
What Is Tchaikapharma High Quality Medicines AD's Net Debt?
As you can see below, Tchaikapharma High Quality Medicines AD had лв9.78m of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. However, it does have лв296.0k in cash offsetting this, leading to net debt of about лв9.49m.
How Healthy Is Tchaikapharma High Quality Medicines AD's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Tchaikapharma High Quality Medicines AD had liabilities of лв13.8m due within 12 months and liabilities of лв3.34m due beyond that. Offsetting this, it had лв296.0k in cash and лв59.1m in receivables that were due within 12 months. So it actually has лв42.2m more liquid assets than total liabilities.
This short term liquidity is a sign that Tchaikapharma High Quality Medicines AD could probably pay off its debt with ease, as its balance sheet is far from stretched. But either way, Tchaikapharma High Quality Medicines AD has virtually no net debt, so it's fair to say it does not have a heavy debt load!
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.
Tchaikapharma High Quality Medicines AD's net debt to EBITDA ratio of about 1.9 suggests only moderate use of debt. And its strong interest cover of 1k times, makes us even more comfortable. Shareholders should be aware that Tchaikapharma High Quality Medicines AD's EBIT was down 79% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Tchaikapharma High Quality Medicines AD will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Tchaikapharma High Quality Medicines AD reported free cash flow worth 12% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Neither Tchaikapharma High Quality Medicines AD's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We think that Tchaikapharma High Quality Medicines AD's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. Case in point: We've spotted 2 warning signs for Tchaikapharma High Quality Medicines AD you should be aware of, and 1 of them doesn't sit too well with us.
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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