Is SMS Lifesciences India (NSE:SMSLIFE) Using Too Much Debt?

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.' 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 can see that SMS Lifesciences India Limited (NSE:SMSLIFE) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for SMS Lifesciences India

What Is SMS Lifesciences India's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 SMS Lifesciences India had ₹706.3m of debt, an increase on ₹479.8m, over one year. However, because it has a cash reserve of ₹60.6m, its net debt is less, at about ₹645.7m.

How Strong Is SMS Lifesciences India's Balance Sheet?

We can see from the most recent balance sheet that SMS Lifesciences India had liabilities of ₹918.1m falling due within a year, and liabilities of ₹565.1m due beyond that. On the other hand, it had cash of ₹60.6m and ₹399.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹1.02b.

SMS Lifesciences India has a market capitalization of ₹1.71b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

SMS Lifesciences India's net debt is sitting at a very reasonable 2.5 times its EBITDA, while its EBIT covered its interest expense just 4.6 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. The bad news is that SMS Lifesciences India saw its EBIT decline by 16% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. The balance sheet is clearly the area to focus on when you are analysing debt. But it is SMS Lifesciences India's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, SMS Lifesciences India saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, SMS Lifesciences India's EBIT growth rate left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its interest cover is not so bad. Overall, it seems to us that SMS Lifesciences India's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. We've identified 2 warning signs with SMS Lifesciences India (at least 1 which can't be ignored) , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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