Is Profarma Distribuidora de Produtos Farmacêuticos (BVMF:PFRM3) Using Too Much Debt?

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, 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 A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Profarma Distribuidora de Produtos Farmacêuticos

What Is Profarma Distribuidora de Produtos Farmacêuticos's Net Debt?

The chart below, which you can click on for greater detail, shows that Profarma Distribuidora de Produtos Farmacêuticos had R$724.1m in debt in September 2020; about the same as the year before. However, because it has a cash reserve of R$521.4m, its net debt is less, at about R$202.7m.

How Healthy Is Profarma Distribuidora de Produtos Farmacêuticos' Balance Sheet?

We can see from the most recent balance sheet that Profarma Distribuidora de Produtos Farmacêuticos had liabilities of R$1.62b falling due within a year, and liabilities of R$654.3m due beyond that. Offsetting these obligations, it had cash of R$521.4m as well as receivables valued at R$1.06b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$701.5m.

This is a mountain of leverage relative to its market capitalization of R$747.9m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Profarma Distribuidora de Produtos Farmacêuticos has a very low debt to EBITDA ratio of 1.5 so it is strange to see weak interest coverage, with last year's EBIT being only 1.8 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. It is well worth noting that Profarma Distribuidora de Produtos Farmacêuticos's EBIT shot up like bamboo after rain, gaining 43% in the last twelve months. That'll make it easier to manage its 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 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. In the last three years, Profarma Distribuidora de Produtos Farmacêuticos created free cash flow amounting to 14% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Neither Profarma Distribuidora de Produtos Farmacêuticos's ability to cover its interest expense with its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. We should also note that Healthcare industry companies like Profarma Distribuidora de Produtos Farmacêuticos commonly do use debt without problems. When we consider all the factors discussed, it seems to us that Profarma Distribuidora de Produtos Farmacêuticos is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 example, we've discovered 3 warning signs for Profarma Distribuidora de Produtos Farmacêuticos (1 is potentially serious!) that you should be aware of before investing here.

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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