Is Recordati Industria Chimica e Farmaceutica (BIT:REC) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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, Recordati Industria Chimica e Farmaceutica S.p.A. (BIT:REC) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Recordati Industria Chimica e Farmaceutica

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

As you can see below, Recordati Industria Chimica e Farmaceutica had €1.84b of debt, at June 2023, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has €528.6m in cash leading to net debt of about €1.31b.

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 €950.2m due within 12 months and liabilities of €1.65b due beyond that. Offsetting this, it had €528.6m in cash and €452.9m in receivables that were due within 12 months. So its liabilities total €1.62b more than the combination of its cash and short-term receivables.

Since publicly traded Recordati Industria Chimica e Farmaceutica shares are worth a total of €9.07b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). 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 1.8 suggests only moderate use of debt. And its commanding EBIT of 12.6 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 18% over the last year, then it will find its debt load easier to manage. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Recordati Industria Chimica e Farmaceutica can strengthen its balance sheet over time. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Recordati Industria Chimica e Farmaceutica produced sturdy free cash flow equating to 74% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, Recordati Industria Chimica e Farmaceutica's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Looking at the bigger picture, we think Recordati Industria Chimica e Farmaceutica's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns 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. Case in point: We've spotted 1 warning sign for Recordati Industria Chimica e Farmaceutica you should be aware of.

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.