Is Pharmanutra (BIT:PHN) A Risky Investment?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Pharmanutra S.p.A. (BIT:PHN) does carry debt. But should shareholders be worried about its use of debt?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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 Pharmanutra

What Is Pharmanutra's Net Debt?

The image below, which you can click on for greater detail, shows that Pharmanutra had debt of €1.92m at the end of September 2020, a reduction from €5.65m over a year. But it also has €16.4m in cash to offset that, meaning it has €14.5m net cash.

How Strong Is Pharmanutra's Balance Sheet?

The latest balance sheet data shows that Pharmanutra had liabilities of €10.3m due within a year, and liabilities of €2.93m falling due after that. Offsetting these obligations, it had cash of €16.4m as well as receivables valued at €18.0m due within 12 months. So it actually has €21.1m more liquid assets than total liabilities.

This short term liquidity is a sign that Pharmanutra could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Pharmanutra has more cash than debt is arguably a good indication that it can manage its debt safely.

In addition to that, we're happy to report that Pharmanutra has boosted its EBIT by 30%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Pharmanutra can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Pharmanutra may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Pharmanutra produced sturdy free cash flow equating to 52% 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.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Pharmanutra has net cash of €14.5m, as well as more liquid assets than liabilities. And we liked the look of last year's 30% year-on-year EBIT growth. So we don't think Pharmanutra's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Pharmanutra (1 is concerning) you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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