Here's Why Sirio Pharma (SZSE:300791) Can Manage Its Debt Responsibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Sirio Pharma Co., Ltd. (SZSE:300791) makes use of debt. But should shareholders be worried about its use of debt?

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. 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. 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 Sirio Pharma

How Much Debt Does Sirio Pharma Carry?

As you can see below, at the end of September 2024, Sirio Pharma had CN¥1.19b of debt, up from CN¥987.8m a year ago. Click the image for more detail. However, it also had CN¥637.4m in cash, and so its net debt is CN¥550.0m.

How Healthy Is Sirio Pharma's Balance Sheet?

The latest balance sheet data shows that Sirio Pharma had liabilities of CN¥751.7m due within a year, and liabilities of CN¥1.96b falling due after that. Offsetting these obligations, it had cash of CN¥637.4m as well as receivables valued at CN¥733.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.34b.

Of course, Sirio Pharma has a market capitalization of CN¥6.75b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While Sirio Pharma's low debt to EBITDA ratio of 0.79 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.4 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Importantly, Sirio Pharma grew its EBIT by 52% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Sirio Pharma can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. In the last three years, Sirio Pharma basically broke even on a free cash flow basis. Some might say that's a concern, when it comes considering how easily it would be for it to down debt.

Our View

When it comes to the balance sheet, the standout positive for Sirio Pharma was the fact that it seems able to grow its EBIT confidently. However, our other observations weren't so heartening. To be specific, it seems about as good at converting EBIT to free cash flow as wet socks are at keeping your feet warm. Considering this range of data points, we think Sirio Pharma is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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 example, we've discovered 1 warning sign for Sirio Pharma that you should be aware of before investing here.

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.