Aurobindo Pharma (NSE:AUROPHARMA) Seems To Use Debt Quite Sensibly

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Aurobindo Pharma Limited (NSE:AUROPHARMA) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Aurobindo Pharma

What Is Aurobindo Pharma's Debt?

As you can see below, Aurobindo Pharma had ₹40.2b of debt at September 2022, down from ₹43.9b a year prior. But on the other hand it also has ₹64.7b in cash, leading to a ₹24.5b net cash position.

How Healthy Is Aurobindo Pharma's Balance Sheet?

According to the last reported balance sheet, Aurobindo Pharma had liabilities of ₹104.5b due within 12 months, and liabilities of ₹11.8b due beyond 12 months. Offsetting these obligations, it had cash of ₹64.7b as well as receivables valued at ₹36.7b due within 12 months. So its liabilities total ₹14.9b more than the combination of its cash and short-term receivables.

Given Aurobindo Pharma has a market capitalization of ₹259.0b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Aurobindo Pharma also has more cash than debt, so we're pretty confident it can manage its debt safely.

It is just as well that Aurobindo Pharma's load is not too heavy, because its EBIT was down 34% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Aurobindo Pharma'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Aurobindo Pharma has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, Aurobindo Pharma recorded free cash flow worth 53% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

We could understand if investors are concerned about Aurobindo Pharma's liabilities, but we can be reassured by the fact it has has net cash of ₹24.5b. So we don't have any problem with Aurobindo Pharma's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Aurobindo Pharma is showing 2 warning signs in our investment analysis , you should know about...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.