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. As with many other companies Laboratorios Farmaceuticos Rovi, S.A. (BME:ROVI) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. 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.
What Is Laboratorios Farmaceuticos Rovi's Debt?
The image below, which you can click on for greater detail, shows that at September 2019 Laboratorios Farmaceuticos Rovi had debt of €22.4m, up from €39.5 in one year. However, it does have €42.5m in cash offsetting this, leading to net cash of €20.1m.
How Healthy Is Laboratorios Farmaceuticos Rovi's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Laboratorios Farmaceuticos Rovi had liabilities of €95.0m due within 12 months and liabilities of €43.3m due beyond that. Offsetting these obligations, it had cash of €42.5m as well as receivables valued at €79.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €16.7m.
Having regard to Laboratorios Farmaceuticos Rovi's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the €1.42b company is short on cash, but still worth keeping an eye on the balance sheet. While it does have liabilities worth noting, Laboratorios Farmaceuticos Rovi also has more cash than debt, so we're pretty confident it can manage its debt safely.
Better yet, Laboratorios Farmaceuticos Rovi grew its EBIT by 142% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. 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 Laboratorios Farmaceuticos Rovi 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. Laboratorios Farmaceuticos Rovi may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Laboratorios Farmaceuticos Rovi burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Laboratorios Farmaceuticos Rovi has €20.1m in net cash. And we liked the look of last year's 142% year-on-year EBIT growth. So we don't have any problem with Laboratorios Farmaceuticos Rovi's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Laboratorios Farmaceuticos Rovi you should be aware of, and 1 of them is a bit unpleasant.
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.