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. 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. We note that Poly Medicure Limited (NSE:POLYMED) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. 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.
Check out our latest analysis for Poly Medicure
What Is Poly Medicure's Debt?
The image below, which you can click on for greater detail, shows that Poly Medicure had debt of ₹1.45b at the end of September 2019, a reduction from ₹1.61b over a year. However, it also had ₹797.3m in cash, and so its net debt is ₹656.3m.
How Healthy Is Poly Medicure's Balance Sheet?
According to the last reported balance sheet, Poly Medicure had liabilities of ₹2.00b due within 12 months, and liabilities of ₹1.10b due beyond 12 months. Offsetting these obligations, it had cash of ₹797.3m as well as receivables valued at ₹1.36b due within 12 months. So its liabilities total ₹938.5m more than the combination of its cash and short-term receivables.
Since publicly traded Poly Medicure shares are worth a total of ₹22.7b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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.
Poly Medicure has a low net debt to EBITDA ratio of only 0.41. And its EBIT easily covers its interest expense, being 17.0 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Another good sign is that Poly Medicure has been able to increase its EBIT by 27% in twelve months, making it easier to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Poly Medicure will need earnings to service that debt. 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Poly Medicure's free cash flow amounted to 25% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Our View
Happily, Poly Medicure's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. We would also note that Medical Equipment industry companies like Poly Medicure commonly do use debt without problems. Looking at the bigger picture, we think Poly Medicure's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. 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. To that end, you should be aware of the 2 warning signs we've spotted with Poly Medicure .
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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. Thank you for reading.