Here's Why Profarma Distribuidora de Produtos Farmacêuticos (BVMF:PFRM3) Is Weighed Down By Its Debt Load

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Profarma Distribuidora de Produtos Farmacêuticos S.A. (BVMF:PFRM3) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 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.

Check out our latest analysis for Profarma Distribuidora de Produtos Farmacêuticos

What Is Profarma Distribuidora de Produtos Farmacêuticos's Debt?

The image below, which you can click on for greater detail, shows that Profarma Distribuidora de Produtos Farmacêuticos had debt of R$598.1m at the end of March 2021, a reduction from R$902.5m over a year. However, because it has a cash reserve of R$232.6m, its net debt is less, at about R$365.5m.

A Look At Profarma Distribuidora de Produtos Farmacêuticos' Liabilities

According to the last reported balance sheet, Profarma Distribuidora de Produtos Farmacêuticos had liabilities of R$1.96b due within 12 months, and liabilities of R$723.8m due beyond 12 months. On the other hand, it had cash of R$232.6m and R$1.31b worth of receivables due within a year. So it has liabilities totalling R$1.14b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's R$784.7m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Profarma Distribuidora de Produtos Farmacêuticos's debt to EBITDA ratio (2.5) suggests that it uses some debt, its interest cover is very weak, at 2.1, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Profarma Distribuidora de Produtos Farmacêuticos grew its EBIT by 2.1% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Profarma Distribuidora de Produtos Farmacêuticos will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Profarma Distribuidora de Produtos Farmacêuticos 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

On the face of it, Profarma Distribuidora de Produtos Farmacêuticos's level of total liabilities 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. Having said that, its ability to grow its EBIT isn't such a worry. It's also worth noting that Profarma Distribuidora de Produtos Farmacêuticos is in the Healthcare industry, which is often considered to be quite defensive. Overall, it seems to us that Profarma Distribuidora de Produtos Farmacêuticos'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. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Profarma Distribuidora de Produtos Farmacêuticos (of which 1 can't be ignored!) 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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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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