These 4 Measures Indicate That Profarma Distribuidora de Produtos Farmacêuticos (BVMF:PFRM3) Is Using Debt Extensively

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Profarma Distribuidora de Produtos Farmacêuticos S.A. (BVMF:PFRM3) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View 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 at June 2022 Profarma Distribuidora de Produtos Farmacêuticos had debt of R$1.04b, up from R$802.8m in one year. However, it does have R$196.6m in cash offsetting this, leading to net debt of about R$840.1m.

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$2.01b due within 12 months, and liabilities of R$773.3m due beyond 12 months. Offsetting this, it had R$196.6m in cash and R$1.50b in receivables that were due within 12 months. So it has liabilities totalling R$1.09b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the R$527.2m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. 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.

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.

While we wouldn't worry about Profarma Distribuidora de Produtos Farmacêuticos's net debt to EBITDA ratio of 3.6, we think its super-low interest cover of 2.0 times is a sign of high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Looking on the bright side, Profarma Distribuidora de Produtos Farmacêuticos boosted its EBIT by a silky 43% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Profarma Distribuidora de Produtos Farmacêuticos's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by 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 conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We should also note that Healthcare industry companies like Profarma Distribuidora de Produtos Farmacêuticos commonly do use debt without problems. We're quite clear that we consider Profarma Distribuidora de Produtos Farmacêuticos to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Profarma Distribuidora de Produtos Farmacêuticos you should be aware of, and 1 of them is a bit concerning.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.