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.' 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 can see that Osmotica Pharmaceuticals plc (NASDAQ:OSMT) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. 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. 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.
How Much Debt Does Osmotica Pharmaceuticals Carry?
The image below, which you can click on for greater detail, shows that Osmotica Pharmaceuticals had debt of US$219.3m at the end of September 2020, a reduction from US$268.1m over a year. However, it also had US$126.1m in cash, and so its net debt is US$93.2m.
How Healthy Is Osmotica Pharmaceuticals's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Osmotica Pharmaceuticals had liabilities of US$54.9m due within 12 months and liabilities of US$221.6m due beyond that. Offsetting these obligations, it had cash of US$126.1m as well as receivables valued at US$21.6m due within 12 months. So it has liabilities totalling US$128.9m more than its cash and near-term receivables, combined.
This deficit isn't so bad because Osmotica Pharmaceuticals is worth US$378.0m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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). 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).
While we wouldn't worry about Osmotica Pharmaceuticals's net debt to EBITDA ratio of 2.9, we think its super-low interest cover of 1.1 times is a sign of high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, the silver lining was that Osmotica Pharmaceuticals achieved a positive EBIT of US$17m in the last twelve months, an improvement on the prior year's loss. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Osmotica Pharmaceuticals's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Osmotica Pharmaceuticals actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Osmotica Pharmaceuticals's interest cover was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to convert EBIT to free cash flow is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about Osmotica Pharmaceuticals's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. For instance, we've identified 1 warning sign for Osmotica Pharmaceuticals that you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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