Bora Pharmaceuticals (GTSM:6472) Takes On Some Risk With Its Use Of 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.' 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. We note that Bora Pharmaceuticals Co., LTD. (GTSM:6472) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. 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 Bora Pharmaceuticals

How Much Debt Does Bora Pharmaceuticals Carry?

As you can see below, at the end of September 2020, Bora Pharmaceuticals had NT$1.16b of debt, up from NT$509.3m a year ago. Click the image for more detail. However, because it has a cash reserve of NT$783.1m, its net debt is less, at about NT$372.9m.

A Look At Bora Pharmaceuticals' Liabilities

According to the last reported balance sheet, Bora Pharmaceuticals had liabilities of NT$662.1m due within 12 months, and liabilities of NT$1.07b due beyond 12 months. Offsetting these obligations, it had cash of NT$783.1m as well as receivables valued at NT$312.9m due within 12 months. So it has liabilities totalling NT$639.8m more than its cash and near-term receivables, combined.

Since publicly traded Bora Pharmaceuticals shares are worth a total of NT$8.71b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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).

Bora Pharmaceuticals has a low net debt to EBITDA ratio of only 1.1. And its EBIT easily covers its interest expense, being 14.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The modesty of its debt load may become crucial for Bora Pharmaceuticals if management cannot prevent a repeat of the 39% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Bora Pharmaceuticals can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Bora Pharmaceuticals burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Bora Pharmaceuticals's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. When we consider all the factors discussed, it seems to us that Bora Pharmaceuticals is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Case in point: We've spotted 5 warning signs for Bora Pharmaceuticals you should be aware of, and 2 of them are a bit unpleasant.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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