Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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. We note that Cipher Pharmaceuticals Inc. (TSE:CPH) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Cipher Pharmaceuticals Carry?
You can click the graphic below for the historical numbers, but it shows that Cipher Pharmaceuticals had US$15.5m of debt in March 2019, down from US$16.5m, one year before. However, it does have US$7.92m in cash offsetting this, leading to net debt of about US$7.61m.
How Healthy Is Cipher Pharmaceuticals’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Cipher Pharmaceuticals had liabilities of US$18.2m due within 12 months and liabilities of US$10.2m due beyond that. On the other hand, it had cash of US$7.92m and US$9.10m worth of receivables due within a year. So its liabilities total US$11.4m more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Cipher Pharmaceuticals is worth US$23.4m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Cipher Pharmaceuticals has net debt of just 0.99 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.5 times the interest expense over the last year. In fact Cipher Pharmaceuticals’s saving grace is its low debt levels, because its EBIT has tanked 68% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Cipher Pharmaceuticals can strengthen its balance sheet over time. 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 we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Cipher Pharmaceuticals recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Cipher Pharmaceuticals’s EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to cover its interest expense with its EBIT isn’t too shabby at all. Taking the abovementioned factors together we do think Cipher Pharmaceuticals’s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. In light of our reservations about the company’s balance sheet, it seems sensible to check if insiders have been selling shares recently.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
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