Is Karo Pharma (STO:KARO) A Risky Investment?

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.' 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. We note that Karo Pharma AB (publ) (STO:KARO) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Karo Pharma

What Is Karo Pharma's Net Debt?

The chart below, which you can click on for greater detail, shows that Karo Pharma had kr5.84b in debt in March 2021; about the same as the year before. However, it also had kr594.5m in cash, and so its net debt is kr5.25b.

A Look At Karo Pharma's Liabilities

The latest balance sheet data shows that Karo Pharma had liabilities of kr5.27b due within a year, and liabilities of kr1.63b falling due after that. Offsetting this, it had kr594.5m in cash and kr736.3m in receivables that were due within 12 months. So its liabilities total kr5.57b more than the combination of its cash and short-term receivables.

Karo Pharma has a market capitalization of kr13.3b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Karo Pharma shareholders face the double whammy of a high net debt to EBITDA ratio (6.3), and fairly weak interest coverage, since EBIT is just 1.3 times the interest expense. The debt burden here is substantial. The good news is that Karo Pharma improved its EBIT by 3.3% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Karo Pharma'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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Karo Pharma saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Karo Pharma's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. Overall, it seems to us that Karo Pharma's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For example Karo Pharma has 2 warning signs (and 1 which shouldn't be ignored) we think you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. 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.
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