These 4 Measures Indicate That Solara Active Pharma Sciences (NSE:SOLARA) Is Using Debt Reasonably Well

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. 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 note that Solara Active Pharma Sciences Limited (NSE:SOLARA) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Solara Active Pharma Sciences

How Much Debt Does Solara Active Pharma Sciences Carry?

The image below, which you can click on for greater detail, shows that at September 2019 Solara Active Pharma Sciences had debt of ₹5.79b, up from ₹5.38b in one year. However, it also had ₹1.30b in cash, and so its net debt is ₹4.49b.

How Healthy Is Solara Active Pharma Sciences's Balance Sheet?

We can see from the most recent balance sheet that Solara Active Pharma Sciences had liabilities of ₹7.63b falling due within a year, and liabilities of ₹3.16b due beyond that. On the other hand, it had cash of ₹1.30b and ₹2.66b worth of receivables due within a year. So it has liabilities totalling ₹6.82b more than its cash and near-term receivables, combined.

Solara Active Pharma Sciences has a market capitalization of ₹11.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

Even though Solara Active Pharma Sciences's debt is only 1.7, its interest cover is really very low at 2.5. This does have us wondering if the company pays high interest because it is considered risky. In any case, it's safe to say the company has meaningful debt. Pleasingly, Solara Active Pharma Sciences is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 101% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Solara Active Pharma Sciences'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.

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. During the last three years, Solara Active Pharma Sciences produced sturdy free cash flow equating to 78% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that Solara Active Pharma Sciences's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its interest cover has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Solara Active Pharma Sciences can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. We'd be motivated to research the stock further if we found out that Solara Active Pharma Sciences insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.

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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.