Is Sirio Pharma (SZSE:300791) Using Too Much Debt?

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.' 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 Sirio Pharma Co., Ltd. (SZSE:300791) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at 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 June 2024, Sirio Pharma had CN¥1.18b of debt, up from CN¥933.4m a year ago. Click the image for more detail. However, it also had CN¥585.5m in cash, and so its net debt is CN¥590.4m.

How Healthy Is Sirio Pharma's Balance Sheet?

The latest balance sheet data shows that Sirio Pharma had liabilities of CN¥751.4m due within a year, and liabilities of CN¥1.92b falling due after that. On the other hand, it had cash of CN¥585.5m and CN¥699.8m worth of receivables due within a year. So its liabilities total CN¥1.39b more than the combination of its cash and short-term receivables.

Sirio Pharma has a market capitalization of CN¥5.49b, so it could very likely raise cash to ameliorate 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.

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.

Looking at its net debt to EBITDA of 0.89 and interest cover of 5.3 times, it seems to us that Sirio Pharma is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Importantly, Sirio Pharma grew its EBIT by 84% 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 it is future earnings, more than anything, that will determine Sirio Pharma's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, Sirio Pharma actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

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. But the other factors we noted above weren't so encouraging. In particular, conversion of EBIT to free cash flow gives us cold feet. 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Sirio Pharma , and understanding them should be part of your investment process.

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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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.