Is Faes Farma (BME:FAE) 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 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. As with many other companies Faes Farma, S.A. (BME:FAE) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Faes Farma

How Much Debt Does Faes Farma Carry?

The chart below, which you can click on for greater detail, shows that Faes Farma had €13.0m in debt in December 2020; about the same as the year before. But on the other hand it also has €93.1m in cash, leading to a €80.2m net cash position.

How Strong Is Faes Farma's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Faes Farma had liabilities of €84.7m due within 12 months and liabilities of €6.59m due beyond that. Offsetting this, it had €93.1m in cash and €105.3m in receivables that were due within 12 months. So it can boast €107.1m more liquid assets than total liabilities.

This surplus suggests that Faes Farma has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Faes Farma has more cash than debt is arguably a good indication that it can manage its debt safely.

And we also note warmly that Faes Farma grew its EBIT by 17% last year, making its debt load easier to handle. 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 Faes Farma'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Faes Farma may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Faes Farma recorded free cash flow worth 60% 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.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Faes Farma has net cash of €80.2m, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 17% over the last year. So we don't think Faes Farma's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Faes Farma you should know about.

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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