Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Alkem Laboratories Limited (NSE:ALKEM) does have debt on its balance sheet. 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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Alkem Laboratories's Debt?
As you can see below, Alkem Laboratories had ₹13.0b of debt at September 2020, down from ₹14.1b a year prior. But it also has ₹16.2b in cash to offset that, meaning it has ₹3.13b net cash.
A Look At Alkem Laboratories' Liabilities
According to the last reported balance sheet, Alkem Laboratories had liabilities of ₹30.1b due within 12 months, and liabilities of ₹3.77b due beyond 12 months. Offsetting this, it had ₹16.2b in cash and ₹18.4b in receivables that were due within 12 months. So it can boast ₹715.4m more liquid assets than total liabilities.
Having regard to Alkem Laboratories' size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the ₹369.2b company is struggling for cash, we still think it's worth monitoring its balance sheet. Simply put, the fact that Alkem Laboratories has more cash than debt is arguably a good indication that it can manage its debt safely.
In addition to that, we're happy to report that Alkem Laboratories has boosted its EBIT by 55%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Alkem Laboratories's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Alkem Laboratories may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Alkem Laboratories's free cash flow amounted to 36% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
While it is always sensible to investigate a company's debt, in this case Alkem Laboratories has ₹3.13b in net cash and a decent-looking balance sheet. And it impressed us with its EBIT growth of 55% over the last year. So is Alkem Laboratories's debt a risk? It doesn't seem so to us. 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. For example, we've discovered 2 warning signs for Alkem Laboratories 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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