These 4 Measures Indicate That Osmotica Pharmaceuticals (NASDAQ:OSMT) Is Using Debt Extensively

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.' 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. As with many other companies Osmotica Pharmaceuticals plc (NASDAQ:OSMT) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. 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 Osmotica Pharmaceuticals

How Much Debt Does Osmotica Pharmaceuticals Carry?

You can click the graphic below for the historical numbers, but it shows that Osmotica Pharmaceuticals had US$219.5m of debt in December 2020, down from US$268.0m, one year before. However, because it has a cash reserve of US$114.1m, its net debt is less, at about US$105.5m.

How Healthy Is Osmotica Pharmaceuticals' Balance Sheet?

We can see from the most recent balance sheet that Osmotica Pharmaceuticals had liabilities of US$55.8m falling due within a year, and liabilities of US$221.3m due beyond that. Offsetting this, it had US$114.1m in cash and US$26.4m in receivables that were due within 12 months. So it has liabilities totalling US$136.6m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of US$191.3m, so it does suggest shareholders should keep an eye on Osmotica Pharmaceuticals' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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

Osmotica Pharmaceuticals shareholders face the double whammy of a high net debt to EBITDA ratio (5.0), and fairly weak interest coverage, since EBIT is just 0.12 times the interest expense. The debt burden here is substantial. Worse, Osmotica Pharmaceuticals's EBIT was down 44% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Osmotica Pharmaceuticals can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, 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.

Our View

On the face of it, Osmotica Pharmaceuticals's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Osmotica Pharmaceuticals's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Osmotica Pharmaceuticals you should know about.

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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