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

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.' 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. 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 assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, 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.

View our latest analysis for Recordati Industria Chimica e Farmaceutica

What Is Recordati Industria Chimica e Farmaceutica's Net Debt?

The image below, which you can click on for greater detail, shows that Recordati Industria Chimica e Farmaceutica had debt of €1.56b at the end of March 2023, a reduction from €1.66b over a year. However, it also had €231.3m in cash, and so its net debt is €1.33b.

How Strong 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 €881.0m due within 12 months and liabilities of €1.45b due beyond that. On the other hand, it had cash of €231.3m and €488.2m worth of receivables due within a year. So it has liabilities totalling €1.61b more than its cash and near-term receivables, combined.

Since publicly traded Recordati Industria Chimica e Farmaceutica shares are worth a total of €8.79b, it seems unlikely that this level of liabilities would be a major threat. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Recordati Industria Chimica e Farmaceutica's net debt to EBITDA ratio of about 1.9 suggests only moderate use of debt. And its commanding EBIT of 13.5 times its interest expense, implies the debt load is as light as a peacock feather. If Recordati Industria Chimica e Farmaceutica can keep growing EBIT at last year's rate of 12% over the last year, then it will find its debt load easier to manage. 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 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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Recordati Industria Chimica e Farmaceutica produced sturdy free cash flow equating to 69% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Recordati Industria Chimica e Farmaceutica's interest cover 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 conversion of EBIT to free cash flow is also very heartening. When we consider the range of factors above, it looks like Recordati Industria Chimica e Farmaceutica is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. For example, we've discovered 1 warning sign for Recordati Industria Chimica e Farmaceutica that you should be aware of before investing here.

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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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.