Profarma Distribuidora de Produtos Farmacêuticos (BVMF:PFRM3) Has A Somewhat Strained Balance Sheet

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?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

Check out our latest analysis for Profarma Distribuidora de Produtos Farmacêuticos

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

As you can see below, at the end of September 2024, Profarma Distribuidora de Produtos Farmacêuticos had R$743.3m of debt, up from R$710.1m a year ago. Click the image for more detail. However, it does have R$231.3m in cash offsetting this, leading to net debt of about R$512.0m.

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$2.57b falling due within a year, and liabilities of R$924.2m due beyond that. On the other hand, it had cash of R$231.3m and R$1.69b worth of receivables due within a year. So it has liabilities totalling R$1.57b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the R$749.2m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Profarma Distribuidora de Produtos Farmacêuticos would probably need a major re-capitalization if its creditors were to demand repayment.

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

Even though Profarma Distribuidora de Produtos Farmacêuticos's debt is only 1.5, its interest cover is really very low at 2.2. This does have us wondering if the company pays high interest because it is considered risky. Either way there's no doubt the stock is using meaningful leverage. Importantly, Profarma Distribuidora de Produtos Farmacêuticos grew its EBIT by 31% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Profarma Distribuidora de Produtos Farmacêuticos's earnings that will influence how the balance sheet holds up in the future. 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Profarma Distribuidora de Produtos Farmacêuticos generated free cash flow amounting to a very robust 93% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

While Profarma Distribuidora de Produtos Farmacêuticos's level of total liabilities has us nervous. For example, its conversion of EBIT to free cash flow and EBIT growth rate give us some confidence in its ability to manage its debt. We should also note that Healthcare industry companies like Profarma Distribuidora de Produtos Farmacêuticos commonly do use debt without problems. We think that Profarma Distribuidora de Produtos Farmacêuticos's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For instance, we've identified 1 warning sign for Profarma Distribuidora de Produtos Farmacêuticos that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.