These 4 Measures Indicate That Laboratorios Farmaceuticos Rovi (BME:ROVI) Is Using Debt Reasonably Well

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 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 can see that Laboratorios Farmaceuticos Rovi, S.A. (BME:ROVI) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. 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.

View our latest analysis for Laboratorios Farmaceuticos Rovi

What Is Laboratorios Farmaceuticos Rovi's Net Debt?

As you can see below, at the end of September 2020, Laboratorios Farmaceuticos Rovi had €53.1m of debt, up from €22.4m a year ago. Click the image for more detail. On the flip side, it has €35.3m in cash leading to net debt of about €17.8m.

A Look At Laboratorios Farmaceuticos Rovi's Liabilities

Zooming in on the latest balance sheet data, we can see that Laboratorios Farmaceuticos Rovi had liabilities of €111.8m due within 12 months and liabilities of €80.4m due beyond that. On the other hand, it had cash of €35.3m and €93.9m worth of receivables due within a year. So its liabilities total €63.1m more than the combination of its cash and short-term receivables.

Given Laboratorios Farmaceuticos Rovi has a market capitalization of €2.10b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Carrying virtually no net debt, Laboratorios Farmaceuticos Rovi has a very light debt load indeed.

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.

Laboratorios Farmaceuticos Rovi has a low net debt to EBITDA ratio of only 0.23. And its EBIT covers its interest expense a whopping 88.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we're happy to report that Laboratorios Farmaceuticos Rovi has boosted its EBIT by 88%, thus reducing the spectre of future debt repayments. 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 Laboratorios Farmaceuticos Rovi'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 company can only pay off debt with cold hard cash, not accounting profits. 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, Laboratorios Farmaceuticos Rovi burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Happily, Laboratorios Farmaceuticos Rovi's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Taking all this data into account, it seems to us that Laboratorios Farmaceuticos Rovi takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Laboratorios Farmaceuticos Rovi , and understanding them should be part of your investment process.

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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