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.' 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 can see that SMS Pharmaceuticals Limited (NSE:SMSPHARMA) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does SMS Pharmaceuticals Carry?
As you can see below, at the end of September 2021, SMS Pharmaceuticals had ₹2.47b of debt, up from ₹1.85b a year ago. Click the image for more detail. However, because it has a cash reserve of ₹300.9m, its net debt is less, at about ₹2.17b.
How Healthy Is SMS Pharmaceuticals' Balance Sheet?
We can see from the most recent balance sheet that SMS Pharmaceuticals had liabilities of ₹2.34b falling due within a year, and liabilities of ₹1.92b due beyond that. Offsetting this, it had ₹300.9m in cash and ₹1.13b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹2.82b.
While this might seem like a lot, it is not so bad since SMS Pharmaceuticals has a market capitalization of ₹9.12b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With net debt sitting at just 1.4 times EBITDA, SMS Pharmaceuticals is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 8.5 times the interest expense over the last year. In addition to that, we're happy to report that SMS Pharmaceuticals has boosted its EBIT by 80%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, SMS Pharmaceuticals saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Based on what we've seen SMS Pharmaceuticals is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to grow its EBIT is pretty flash. Looking at all this data makes us feel a little cautious about SMS Pharmaceuticals's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for SMS Pharmaceuticals you should be aware of.
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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