Bal Pharma (NSE:BALPHARMA) Use Of Debt Could Be Considered Risky

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Bal Pharma Limited (NSE:BALPHARMA) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Bal Pharma

What Is Bal Pharma's Net Debt?

As you can see below, Bal Pharma had ₹1.15b of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. However, it also had ₹65.9m in cash, and so its net debt is ₹1.08b.

How Strong Is Bal Pharma's Balance Sheet?

We can see from the most recent balance sheet that Bal Pharma had liabilities of ₹1.70b falling due within a year, and liabilities of ₹371.6m due beyond that. Offsetting this, it had ₹65.9m in cash and ₹725.3m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹1.28b.

The deficiency here weighs heavily on the ₹783.7m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Bal Pharma would likely require a major re-capitalisation if it had to pay its creditors today.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Weak interest cover of 0.46 times and a disturbingly high net debt to EBITDA ratio of 9.2 hit our confidence in Bal Pharma like a one-two punch to the gut. The debt burden here is substantial. Worse, Bal Pharma's EBIT was down 34% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Bal Pharma 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. Happily for any shareholders, Bal Pharma actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

To be frank both Bal Pharma's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. After considering the datapoints discussed, we think Bal Pharma has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - Bal Pharma has 4 warning signs (and 2 which can't be ignored) we think 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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