David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Collegium Pharmaceutical, Inc. (NASDAQ:COLL) makes use of debt. 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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
What Is Collegium Pharmaceutical's Net Debt?
As you can see below, at the end of December 2020, Collegium Pharmaceutical had US$257.1m of debt, up from US$11.5m a year ago. Click the image for more detail. However, it also had US$174.1m in cash, and so its net debt is US$83.0m.
How Healthy Is Collegium Pharmaceutical's Balance Sheet?
According to the last reported balance sheet, Collegium Pharmaceutical had liabilities of US$239.5m due within 12 months, and liabilities of US$218.4m due beyond 12 months. Offsetting this, it had US$174.1m in cash and US$83.3m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$200.4m.
This deficit isn't so bad because Collegium Pharmaceutical is worth US$785.0m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Collegium Pharmaceutical has a very low debt to EBITDA ratio of 0.70 so it is strange to see weak interest coverage, with last year's EBIT being only 2.0 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. We also note that Collegium Pharmaceutical improved its EBIT from a last year's loss to a positive US$56m. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Collegium Pharmaceutical 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Collegium Pharmaceutical burned a lot of cash. 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.
Both Collegium Pharmaceutical's conversion of EBIT to free cash flow and its interest cover were discouraging. But at least its net debt to EBITDA is a gleaming silver lining to those clouds. When we consider all the factors discussed, it seems to us that Collegium Pharmaceutical 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. 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. We've identified 2 warning signs with Collegium Pharmaceutical (at least 1 which is concerning) , and understanding them should be part of your investment process.
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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