Is Hikma Pharmaceuticals (LON:HIK) A Risky Investment?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies Hikma Pharmaceuticals PLC (LON:HIK) makes use of debt. But the more important question is: how much risk is that debt creating?

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. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Hikma Pharmaceuticals

What Is Hikma Pharmaceuticals's Debt?

The image below, which you can click on for greater detail, shows that at December 2022 Hikma Pharmaceuticals had debt of US$1.21b, up from US$763.0m in one year. However, because it has a cash reserve of US$292.0m, its net debt is less, at about US$921.0m.

A Look At Hikma Pharmaceuticals' Liabilities

The latest balance sheet data shows that Hikma Pharmaceuticals had liabilities of US$1.08b due within a year, and liabilities of US$1.25b falling due after that. Offsetting this, it had US$292.0m in cash and US$841.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.19b.

This deficit isn't so bad because Hikma Pharmaceuticals is worth US$5.27b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). 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).

Hikma Pharmaceuticals's net debt is only 1.2 times its EBITDA. And its EBIT easily covers its interest expense, being 10.6 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Hikma Pharmaceuticals saw its EBIT drop by 6.8% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. 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 Hikma Pharmaceuticals'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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Hikma Pharmaceuticals recorded free cash flow worth 55% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

When it comes to the balance sheet, the standout positive for Hikma Pharmaceuticals was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. For example, its EBIT growth rate makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that Hikma Pharmaceuticals is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. Case in point: We've spotted 3 warning signs for Hikma Pharmaceuticals you should be aware of.

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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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.