Aarey Drugs & Pharmaceuticals (NSE:AAREYDRUGS) Has A Pretty Healthy Balance Sheet

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Aarey Drugs & Pharmaceuticals Limited (NSE:AAREYDRUGS) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Aarey Drugs & Pharmaceuticals

How Much Debt Does Aarey Drugs & Pharmaceuticals Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Aarey Drugs & Pharmaceuticals had ₹373.7m of debt, an increase on ₹242.2m, over one year. However, it does have ₹74.6m in cash offsetting this, leading to net debt of about ₹299.2m.

How Strong Is Aarey Drugs & Pharmaceuticals' Balance Sheet?

The latest balance sheet data shows that Aarey Drugs & Pharmaceuticals had liabilities of ₹1.10b due within a year, and liabilities of ₹52.2m falling due after that. Offsetting this, it had ₹74.6m in cash and ₹1.39b in receivables that were due within 12 months. So it actually has ₹316.6m more liquid assets than total liabilities.

This surplus suggests that Aarey Drugs & Pharmaceuticals is using debt in a way that is appears to be both safe and conservative. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Aarey Drugs & Pharmaceuticals has a debt to EBITDA ratio of 3.5 and its EBIT covered its interest expense 5.8 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Also relevant is that Aarey Drugs & Pharmaceuticals has grown its EBIT by a very respectable 22% in the last year, thus enhancing its ability to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Aarey Drugs & Pharmaceuticals will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Aarey Drugs & Pharmaceuticals saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Aarey Drugs & Pharmaceuticals's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to grow its EBIT is pretty flash. When we consider all the elements mentioned above, it seems to us that Aarey Drugs & Pharmaceuticals is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. Case in point: We've spotted 3 warning signs for Aarey Drugs & Pharmaceuticals you should be aware of, and 1 of them is a bit unpleasant.

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.