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

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, Laboratorios Farmaceuticos Rovi, S.A. (BME:ROVI) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Laboratorios Farmaceuticos Rovi

How Much Debt Does Laboratorios Farmaceuticos Rovi Carry?

The image below, which you can click on for greater detail, shows that at September 2024 Laboratorios Farmaceuticos Rovi had debt of €112.2m, up from €48.8m in one year. However, because it has a cash reserve of €17.6m, its net debt is less, at about €94.6m.

A Look At Laboratorios Farmaceuticos Rovi's Liabilities

The latest balance sheet data shows that Laboratorios Farmaceuticos Rovi had liabilities of €221.5m due within a year, and liabilities of €98.2m falling due after that. On the other hand, it had cash of €17.6m and €185.5m worth of receivables due within a year. So its liabilities total €116.6m more than the combination of its cash and short-term receivables.

Since publicly traded Laboratorios Farmaceuticos Rovi shares are worth a total of €2.84b, 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.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Laboratorios Farmaceuticos Rovi has a low net debt to EBITDA ratio of only 0.40. And its EBIT easily covers its interest expense, being 69.7 times the size. So we're pretty relaxed about its super-conservative use of debt. On the other hand, Laboratorios Farmaceuticos Rovi's EBIT dived 16%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Laboratorios Farmaceuticos Rovi can strengthen its balance sheet over time. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Laboratorios Farmaceuticos Rovi's free cash flow amounted to 39% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Laboratorios Farmaceuticos Rovi's interest cover was a real positive on this analysis, as was its net debt to EBITDA. In contrast, our confidence was undermined by its apparent struggle to grow its EBIT. Considering this range of data points, we think Laboratorios Farmaceuticos Rovi is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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 Laboratorios Farmaceuticos Rovi is showing 1 warning sign in our investment analysis , you should know about...

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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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.