Is Laboratorios Farmaceuticos Rovi (BME:ROVI) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Laboratorios Farmaceuticos Rovi, S.A. (BME:ROVI) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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. 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 Laboratorios Farmaceuticos Rovi

What Is Laboratorios Farmaceuticos Rovi's Net Debt?

As you can see below, Laboratorios Farmaceuticos Rovi had €55.8m of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. However, it does have €144.0m in cash offsetting this, leading to net cash of €88.2m.

How Strong Is Laboratorios Farmaceuticos Rovi's Balance Sheet?

We can see from the most recent balance sheet that Laboratorios Farmaceuticos Rovi had liabilities of €159.4m falling due within a year, and liabilities of €72.6m due beyond that. Offsetting this, it had €144.0m in cash and €109.6m in receivables that were due within 12 months. So it actually has €21.5m more liquid assets than total liabilities.

This state of affairs indicates that Laboratorios Farmaceuticos Rovi's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the €4.14b company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that Laboratorios Farmaceuticos Rovi has more cash than debt is arguably a good indication that it can manage its debt safely.

Even more impressive was the fact that Laboratorios Farmaceuticos Rovi grew its EBIT by 131% over twelve months. That boost will make it even easier to pay down debt going forward. 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 Laboratorios Farmaceuticos Rovi'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. While Laboratorios Farmaceuticos Rovi has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last three years, Laboratorios Farmaceuticos Rovi's free cash flow amounted to 28% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Summing up

While it is always sensible to investigate a company's debt, in this case Laboratorios Farmaceuticos Rovi has €88.2m in net cash and a decent-looking balance sheet. And we liked the look of last year's 131% year-on-year EBIT growth. So is Laboratorios Farmaceuticos Rovi's debt a risk? It doesn't seem so to us. 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. Be aware that Laboratorios Farmaceuticos Rovi is showing 1 warning sign in our investment analysis , 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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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.