S.C. Ropharma (BVB:RPH) Takes On Some Risk With Its Use Of Debt

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. We note that S.C. Ropharma S.A. (BVB:RPH) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for S.C. Ropharma

What Is S.C. Ropharma's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 S.C. Ropharma had RON90.9m of debt, an increase on RON84.0m, over one year. However, it does have RON14.7m in cash offsetting this, leading to net debt of about RON76.3m.

A Look At S.C. Ropharma's Liabilities

According to the last reported balance sheet, S.C. Ropharma had liabilities of RON358.4m due within 12 months, and liabilities of RON90.9m due beyond 12 months. On the other hand, it had cash of RON14.7m and RON219.5m worth of receivables due within a year. So its liabilities total RON215.1m more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the RON117.2m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, S.C. Ropharma would likely require a major re-capitalisation if it had to pay its creditors today.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While S.C. Ropharma has a quite reasonable net debt to EBITDA multiple of 2.2, its interest cover seems weak, at 1.9. The main reason for this is that it has such high depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) Either way there's no doubt the stock is using meaningful leverage. Importantly, S.C. Ropharma grew its EBIT by 40% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is S.C. Ropharma's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, S.C. Ropharma saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both S.C. Ropharma's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that S.C. Ropharma's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. Be aware that S.C. Ropharma is showing 3 warning signs in our investment analysis , and 2 of those are potentially serious...

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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