These 4 Measures Indicate That Aarti Pharmalabs (NSE:AARTIPHARM) Is Using Debt Reasonably Well

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.' 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. Importantly, Aarti Pharmalabs Limited (NSE:AARTIPHARM) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Aarti Pharmalabs

What Is Aarti Pharmalabs's Debt?

You can click the graphic below for the historical numbers, but it shows that Aarti Pharmalabs had ₹2.17b of debt in September 2023, down from ₹2.98b, one year before. However, it also had ₹697.7m in cash, and so its net debt is ₹1.47b.

A Look At Aarti Pharmalabs' Liabilities

We can see from the most recent balance sheet that Aarti Pharmalabs had liabilities of ₹5.59b falling due within a year, and liabilities of ₹965.9m due beyond that. On the other hand, it had cash of ₹697.7m and ₹4.36b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹1.50b.

Of course, Aarti Pharmalabs has a market capitalization of ₹41.6b, so these liabilities are probably manageable. 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.

Aarti Pharmalabs has a low net debt to EBITDA ratio of only 0.43. And its EBIT covers its interest expense a whopping 18.7 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that Aarti Pharmalabs saw its EBIT decline by 6.4% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Aarti Pharmalabs'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.

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. Over the last three years, Aarti Pharmalabs recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Aarti Pharmalabs's interest cover was a real positive on this analysis, as was its net debt to EBITDA. In contrast, our confidence was undermined by its apparent struggle to convert EBIT to free cash flow. Looking at all this data makes us feel a little cautious about Aarti Pharmalabs's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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 Pharmalabs that you should be aware of before investing here.

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. 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.