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 can see that Sopharma AD (BUL:SFA) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. 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, 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 Sopharma AD's Debt?
You can click the graphic below for the historical numbers, but it shows that Sopharma AD had лв357.6m of debt in December 2020, down from лв373.2m, one year before. On the flip side, it has лв25.5m in cash leading to net debt of about лв332.1m.
How Healthy Is Sopharma AD's Balance Sheet?
The latest balance sheet data shows that Sopharma AD had liabilities of лв543.6m due within a year, and liabilities of лв133.9m falling due after that. On the other hand, it had cash of лв25.5m and лв280.9m worth of receivables due within a year. So it has liabilities totalling лв371.1m more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of лв420.1m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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 3.6 times its EBITDA, and its EBIT cover its interest expense 6.4 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. The bad news is that Sopharma AD saw its EBIT decline by 17% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. The balance sheet is clearly the area to focus on when you are analysing debt. 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, 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. During the last three years, Sopharma AD burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, Sopharma AD's EBIT growth rate left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, it seems to us that Sopharma AD's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For instance, we've identified 4 warning signs for Sopharma AD (2 are a bit concerning) you should be aware of.
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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