Here's Why Recordati Industria Chimica e Farmaceutica (BIT:REC) Can Manage Its Debt Responsibly

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.' 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, Recordati Industria Chimica e Farmaceutica S.p.A. (BIT:REC) does carry debt. But the real question is whether this debt is making the company risky.

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Recordati Industria Chimica e Farmaceutica

How Much Debt Does Recordati Industria Chimica e Farmaceutica Carry?

As you can see below, Recordati Industria Chimica e Farmaceutica had €1.09b of debt, at March 2021, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has €250.1m in cash leading to net debt of about €840.5m.

How Healthy Is Recordati Industria Chimica e Farmaceutica's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Recordati Industria Chimica e Farmaceutica had liabilities of €628.6m due within 12 months and liabilities of €879.8m due beyond that. On the other hand, it had cash of €250.1m and €343.1m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €915.2m.

Of course, Recordati Industria Chimica e Farmaceutica has a titanic market capitalization of €9.47b, 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 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).

Recordati Industria Chimica e Farmaceutica's net debt to EBITDA ratio of about 1.6 suggests only moderate use of debt. And its strong interest cover of 22.9 times, makes us even more comfortable. On the other hand, Recordati Industria Chimica e Farmaceutica saw its EBIT drop by 9.0% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Recordati Industria Chimica e Farmaceutica's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Recordati Industria Chimica e Farmaceutica recorded free cash flow of 29% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

On our analysis Recordati Industria Chimica e Farmaceutica's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its EBIT growth rate makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Recordati Industria Chimica e Farmaceutica's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Recordati Industria Chimica e Farmaceutica , and understanding them should be part of your investment process.

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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