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.' 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. Importantly, Solara Active Pharma Sciences Limited (NSE:SOLARA) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Solara Active Pharma Sciences's Debt?
The image below, which you can click on for greater detail, shows that Solara Active Pharma Sciences had debt of ₹5.34b at the end of March 2019, a reduction from ₹6.33b over a year. On the flip side, it has ₹761.6m in cash leading to net debt of about ₹4.58b.
A Look At Solara Active Pharma Sciences's Liabilities
The latest balance sheet data shows that Solara Active Pharma Sciences had liabilities of ₹6.55b due within a year, and liabilities of ₹3.44b falling due after that. Offsetting this, it had ₹761.6m in cash and ₹3.34b in receivables that were due within 12 months. So its liabilities total ₹5.90b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Solara Active Pharma Sciences is worth ₹10.8b, 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Solara Active Pharma Sciences has a quite reasonable net debt to EBITDA multiple of 1.8, its interest cover seems weak, at 2.2. This does suggest the company is paying fairly high interest rates. In any case, it's safe to say the company has meaningful debt. Pleasingly, Solara Active Pharma Sciences is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 177% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Solara Active Pharma Sciences will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Solara Active Pharma Sciences produced sturdy free cash flow equating to 66% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
On our analysis Solara Active Pharma Sciences's EBIT growth rate should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. To be specific, it seems about as good at covering its interest expense with its EBIT as wet socks are at keeping your feet warm. Considering this range of data points, we think Solara Active Pharma Sciences is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. We'd be motivated to research the stock further if we found out that Solara Active Pharma Sciences insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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.
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.
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. Thank you for reading.