We Think Laboratorios Farmaceuticos Rovi (BME:ROVI) Can Stay On Top Of Its Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Laboratorios Farmaceuticos Rovi, S.A. (BME:ROVI) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Laboratorios Farmaceuticos Rovi

How Much Debt Does Laboratorios Farmaceuticos Rovi Carry?

You can click the graphic below for the historical numbers, but it shows that Laboratorios Farmaceuticos Rovi had €56.9m of debt in December 2020, down from €63.9m, one year before. However, because it has a cash reserve of €53.2m, its net debt is less, at about €3.66m.

How Strong Is Laboratorios Farmaceuticos Rovi's Balance Sheet?

The latest balance sheet data shows that Laboratorios Farmaceuticos Rovi had liabilities of €122.9m due within a year, and liabilities of €77.9m falling due after that. Offsetting these obligations, it had cash of €53.2m as well as receivables valued at €82.0m due within 12 months. So it has liabilities totalling €65.5m more than its cash and near-term receivables, combined.

Since publicly traded Laboratorios Farmaceuticos Rovi shares are worth a total of €2.58b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. But either way, Laboratorios Farmaceuticos Rovi has virtually no net debt, so it's fair to say it does not have a heavy debt load!

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Laboratorios Farmaceuticos Rovi has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.04 and EBIT of 96.8 times the interest expense. So relative to past earnings, the debt load seems trivial. On top of that, Laboratorios Farmaceuticos Rovi grew its EBIT by 84% over the last twelve months, and that growth will make it easier to handle its debt. 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'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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Laboratorios Farmaceuticos Rovi saw substantial negative free cash flow, in total. 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

The good news is that Laboratorios Farmaceuticos Rovi's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. 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. Over time, share prices tend to follow earnings per share, so if you're interested in Laboratorios Farmaceuticos Rovi, you may well want to click here to check an interactive graph of its earnings per share history.

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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