Does Aarti Drugs (NSE:AARTIDRUGS) Have A Healthy Balance Sheet?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 can see that Aarti Drugs Limited (NSE:AARTIDRUGS) does use debt in its business. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Aarti Drugs

What Is Aarti Drugs's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Aarti Drugs had ₹3.29b of debt in September 2020, down from ₹4.39b, one year before. On the flip side, it has ₹229.6m in cash leading to net debt of about ₹3.07b.

How Healthy Is Aarti Drugs' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Aarti Drugs had liabilities of ₹6.41b due within 12 months and liabilities of ₹2.90b due beyond that. On the other hand, it had cash of ₹229.6m and ₹6.04b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹3.04b.

Of course, Aarti Drugs has a market capitalization of ₹64.3b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Aarti Drugs's net debt is only 0.72 times its EBITDA. And its EBIT covers its interest expense a whopping 15.2 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we're happy to report that Aarti Drugs has boosted its EBIT by 88%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Aarti Drugs'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Aarti Drugs's free cash flow amounted to 48% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Aarti Drugs's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its EBIT growth rate also supports that impression! Zooming out, Aarti Drugs seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for Aarti Drugs 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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