Here's Why Medexus Pharmaceuticals (TSE:MDP) Has A Meaningful Debt Burden

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We note that Medexus Pharmaceuticals Inc. (TSE:MDP) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Medexus Pharmaceuticals

What Is Medexus Pharmaceuticals's Debt?

You can click the graphic below for the historical numbers, but it shows that Medexus Pharmaceuticals had US$51.7m of debt in December 2023, down from US$65.0m, one year before. However, it also had US$8.21m in cash, and so its net debt is US$43.5m.

How Healthy Is Medexus Pharmaceuticals' Balance Sheet?

The latest balance sheet data shows that Medexus Pharmaceuticals had liabilities of US$66.5m due within a year, and liabilities of US$64.3m falling due after that. Offsetting these obligations, it had cash of US$8.21m as well as receivables valued at US$22.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$100.4m.

This deficit casts a shadow over the US$29.5m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Medexus Pharmaceuticals would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Even though Medexus Pharmaceuticals's debt is only 2.4, its interest cover is really very low at 0.87. This does suggest the company is paying fairly high interest rates. In any case, it's safe to say the company has meaningful debt. Pleasingly, Medexus Pharmaceuticals is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 158% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Medexus Pharmaceuticals's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last two years, Medexus Pharmaceuticals generated free cash flow amounting to a very robust 98% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

While Medexus Pharmaceuticals's level of total liabilities has us nervous. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. When we consider all the factors discussed, it seems to us that Medexus Pharmaceuticals is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Medexus Pharmaceuticals (1 doesn't sit too well with us) 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.