Torrent Pharmaceuticals (NSE:TORNTPHARM) Seems To Use Debt Quite Sensibly

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. Importantly, Torrent Pharmaceuticals Limited (NSE:TORNTPHARM) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See 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 ₹51.0b of debt in March 2021, down from ₹58.0b, one year before. However, it does have ₹8.64b in cash offsetting this, leading to net debt of about ₹42.3b.

A Look At Torrent Pharmaceuticals' Liabilities

The latest balance sheet data shows that Torrent Pharmaceuticals had liabilities of ₹48.9b due within a year, and liabilities of ₹33.5b falling due after that. Offsetting this, it had ₹8.64b in cash and ₹15.3b in receivables that were due within 12 months. So its liabilities total ₹58.5b more than the combination of its cash and short-term receivables.

Of course, Torrent Pharmaceuticals has a market capitalization of ₹494.8b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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).

Torrent Pharmaceuticals has net debt worth 1.7 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 5.1 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. We note that Torrent Pharmaceuticals grew its EBIT by 20% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. 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.

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. During the last three years, Torrent Pharmaceuticals generated free cash flow amounting to a very robust 81% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Torrent Pharmaceuticals's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Looking at the bigger picture, we think Torrent Pharmaceuticals's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Torrent Pharmaceuticals is showing 2 warning signs in our investment analysis , you should know about...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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