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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Innovative Pharmaceutical Biotech Limited (HKG:399) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Innovative Pharmaceutical Biotech's Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Innovative Pharmaceutical Biotech had HK$919.6m of debt, an increase on HK$822.9m, over one year. And it doesn't have much cash, so its net debt is about the same.
How Strong Is Innovative Pharmaceutical Biotech's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Innovative Pharmaceutical Biotech had liabilities of HK$730.1m due within 12 months and liabilities of HK$200.9m due beyond that. Offsetting this, it had HK$11.9m in cash and HK$12.9m in receivables that were due within 12 months. So its liabilities total HK$906.1m more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the HK$388.0m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Innovative Pharmaceutical Biotech would probably need a major re-capitalization if its creditors were to demand repayment. When analysing debt levels, the balance sheet is the obvious place to start. But it is Innovative Pharmaceutical Biotech's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Over 12 months, Innovative Pharmaceutical Biotech made a loss at the EBIT level, and saw its revenue drop to HK$11m, which is a fall of 46%. That makes us nervous, to say the least.
While Innovative Pharmaceutical Biotech's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost HK$28m at the EBIT level. Considering that alongside the liabilities mentioned above make us nervous about the company. It would need to improve its operations quickly for us to be interested in it. Not least because it burned through HK$32m in negative free cash flow over the last year. So suffice it to say we consider the stock to be risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 4 warning signs with Innovative Pharmaceutical Biotech (at least 2 which are a bit unpleasant) , 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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