Here's Why Dermapharm Holding (ETR:DMP) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Dermapharm Holding SE (ETR:DMP) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. 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. 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.

See our latest analysis for Dermapharm Holding

What Is Dermapharm Holding's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Dermapharm Holding had €606.0m of debt, an increase on €526.5m, over one year. However, because it has a cash reserve of €110.0m, its net debt is less, at about €496.0m.

How Healthy Is Dermapharm Holding's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Dermapharm Holding had liabilities of €134.2m due within 12 months and liabilities of €783.6m due beyond that. On the other hand, it had cash of €110.0m and €65.5m worth of receivables due within a year. So its liabilities total €742.3m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Dermapharm Holding is worth €3.32b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Dermapharm Holding has a debt to EBITDA ratio of 3.4, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 14.2 is very high, suggesting that the interest expense on the debt is currently quite low. If Dermapharm Holding can keep growing EBIT at last year's rate of 20% over the last year, then it will find its debt load easier to manage. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Dermapharm Holding'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Dermapharm Holding produced sturdy free cash flow equating to 72% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, Dermapharm Holding's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its net debt to EBITDA does undermine this impression a bit. When we consider the range of factors above, it looks like Dermapharm Holding is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. Be aware that Dermapharm Holding is showing 2 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. 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.
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