Here's Why Torrent Pharmaceuticals (NSE:TORNTPHARM) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that Torrent Pharmaceuticals Limited (NSE:TORNTPHARM) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Torrent Pharmaceuticals

What Is Torrent Pharmaceuticals's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Torrent Pharmaceuticals had ₹43.4b of debt in September 2021, down from ₹56.8b, one year before. However, it does have ₹6.49b in cash offsetting this, leading to net debt of about ₹36.9b.

How Strong Is Torrent Pharmaceuticals' Balance Sheet?

We can see from the most recent balance sheet that Torrent Pharmaceuticals had liabilities of ₹45.7b falling due within a year, and liabilities of ₹29.0b due beyond that. On the other hand, it had cash of ₹6.49b and ₹15.6b worth of receivables due within a year. So it has liabilities totalling ₹52.5b more than its cash and near-term receivables, combined.

Given Torrent Pharmaceuticals has a market capitalization of ₹550.4b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Torrent Pharmaceuticals's low debt to EBITDA ratio of 1.5 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.3 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. The good news is that Torrent Pharmaceuticals has increased its EBIT by 7.7% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Torrent Pharmaceuticals'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Torrent Pharmaceuticals produced sturdy free cash flow equating to 77% 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 Torrent Pharmaceuticals's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And we also thought its EBIT growth rate was a positive. Taking all this data into account, it seems to us that Torrent Pharmaceuticals takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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. To that end, you should be aware of the 2 warning signs we've spotted with Torrent 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.