Here's Why SMS Pharmaceuticals (NSE:SMSPHARMA) Can Manage Its Debt Responsibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that SMS Pharmaceuticals Limited (NSE:SMSPHARMA) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for SMS Pharmaceuticals

What Is SMS Pharmaceuticals's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 SMS Pharmaceuticals had debt of ₹2.80b, up from ₹2.53b in one year. However, because it has a cash reserve of ₹362.0m, its net debt is less, at about ₹2.44b.

How Strong Is SMS Pharmaceuticals' Balance Sheet?

According to the last reported balance sheet, SMS Pharmaceuticals had liabilities of ₹3.32b due within 12 months, and liabilities of ₹1.66b due beyond 12 months. On the other hand, it had cash of ₹362.0m and ₹2.40b worth of receivables due within a year. So it has liabilities totalling ₹2.22b more than its cash and near-term receivables, combined.

Of course, SMS Pharmaceuticals has a market capitalization of ₹20.4b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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

SMS Pharmaceuticals's net debt is sitting at a very reasonable 2.1 times its EBITDA, while its EBIT covered its interest expense just 3.6 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Pleasingly, SMS Pharmaceuticals is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 274% gain in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since SMS Pharmaceuticals will need earnings to service that debt. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, SMS Pharmaceuticals created free cash flow amounting to 4.4% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

When it comes to the balance sheet, the standout positive for SMS Pharmaceuticals was the fact that it seems able to grow its EBIT confidently. However, our other observations weren't so heartening. To be specific, it seems about as good at converting EBIT to free cash flow as wet socks are at keeping your feet warm. When we consider all the elements mentioned above, it seems to us that SMS Pharmaceuticals is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. For example, we've discovered 2 warning signs for SMS Pharmaceuticals 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.

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