Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about. 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. As with many other companies Strides Pharma Science Limited (NSE:STAR) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Strides Pharma Science’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Strides Pharma Science had ₹32.5b of debt, an increase on ₹25.5b, over one year. On the flip side, it has ₹7.92b in cash leading to net debt of about ₹24.6b.
A Look At Strides Pharma Science’s Liabilities
The latest balance sheet data shows that Strides Pharma Science had liabilities of ₹27.0b due within a year, and liabilities of ₹25.0b falling due after that. On the other hand, it had cash of ₹7.92b and ₹11.2b worth of receivables due within a year. So it has liabilities totalling ₹32.9b more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company’s market capitalization of ₹29.0b, we think shareholders really should watch Strides Pharma Science’s debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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).
While Strides Pharma Science’s debt to EBITDA ratio (4.6) suggests that it uses some debt, its interest cover is very weak, at 2.4, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. The good news is that Strides Pharma Science grew its EBIT a smooth 52% over the last twelve months. Like a mother’s loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Strides Pharma Science’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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Strides Pharma Science burned a lot of cash. 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.
Mulling over Strides Pharma Science’s attempt at converting EBIT to free cash flow, we’re certainly not enthusiastic. But at least it’s pretty decent at growing its EBIT; that’s encouraging. Overall, we think it’s fair to say that Strides Pharma Science has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. In light of our reservations about the company’s balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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