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.' 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 PuraPharm Corporation Limited (HKG:1498) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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.
How Much Debt Does PuraPharm Carry?
As you can see below, PuraPharm had HK$386.8m of debt at June 2020, down from HK$490.2m a year prior. However, it also had HK$127.8m in cash, and so its net debt is HK$259.0m.
How Strong Is PuraPharm's Balance Sheet?
We can see from the most recent balance sheet that PuraPharm had liabilities of HK$586.1m falling due within a year, and liabilities of HK$173.5m due beyond that. On the other hand, it had cash of HK$127.8m and HK$220.9m worth of receivables due within a year. So it has liabilities totalling HK$411.0m more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of HK$302.6m, we think shareholders really should watch PuraPharm's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. 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 PuraPharm'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.
In the last year PuraPharm had a loss before interest and tax, and actually shrunk its revenue by 7.2%, to HK$643m. That's not what we would hope to see.
Over the last twelve months PuraPharm produced an earnings before interest and tax (EBIT) loss. Its EBIT loss was a whopping HK$42m. When we look at that alongside the significant liabilities, we're not particularly confident about the company. It would need to improve its operations quickly for us to be interested in it. It's fair to say the loss of HK$171m didn't encourage us either; we'd like to see a profit. And until that time we think this is a risky stock. 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. For example, we've discovered 4 warning signs for PuraPharm (1 is significant!) that you should be aware of before investing here.
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. 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.
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