We Think Sotac Pharmaceuticals (NSE:SOTAC) Is Taking Some Risk With Its Debt

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.' 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 Sotac Pharmaceuticals Limited (NSE:SOTAC) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Sotac Pharmaceuticals

What Is Sotac Pharmaceuticals's Debt?

As you can see below, at the end of September 2024, Sotac Pharmaceuticals had ₹279.9m of debt, up from ₹210.2m a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.

A Look At Sotac Pharmaceuticals' Liabilities

The latest balance sheet data shows that Sotac Pharmaceuticals had liabilities of ₹530.0m due within a year, and liabilities of ₹115.8m falling due after that. On the other hand, it had cash of ₹5.21m and ₹281.3m worth of receivables due within a year. So it has liabilities totalling ₹359.2m more than its cash and near-term receivables, combined.

Sotac Pharmaceuticals has a market capitalization of ₹1.02b, 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 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). 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).

Sotac Pharmaceuticals's debt is 3.2 times its EBITDA, and its EBIT cover its interest expense 3.7 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Even more troubling is the fact that Sotac Pharmaceuticals actually let its EBIT decrease by 6.8% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Sotac Pharmaceuticals'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, Sotac 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.

Our View

Mulling over Sotac Pharmaceuticals's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least its level of total liabilities is not so bad. Looking at the bigger picture, it seems clear to us that Sotac Pharmaceuticals's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 2 warning signs we've spotted with Sotac Pharmaceuticals .

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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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.