Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Faes Farma, S.A. (BME:FAE) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Faes Farma's Net Debt?
As you can see below, Faes Farma had €15.7m of debt at June 2019, down from €52.9m a year prior. But it also has €56.1m in cash to offset that, meaning it has €40.5m net cash.
How Healthy Is Faes Farma's Balance Sheet?
The latest balance sheet data shows that Faes Farma had liabilities of €73.8m due within a year, and liabilities of €17.6m falling due after that. On the other hand, it had cash of €56.1m and €92.7m worth of receivables due within a year. So it can boast €57.4m more liquid assets than total liabilities.
This surplus suggests that Faes Farma has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Faes Farma boasts net cash, so it's fair to say it does not have a heavy debt load!
In addition to that, we're happy to report that Faes Farma has boosted its EBIT by 37%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Faes Farma 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Faes Farma 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. Over the most recent three years, Faes Farma recorded free cash flow worth 64% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
While it is always sensible to investigate a company's debt, in this case Faes Farma has €40.5m in net cash and a decent-looking balance sheet. And we liked the look of last year's 37% year-on-year EBIT growth. So is Faes Farma's debt a risk? It doesn't seem so to us. Over time, share prices tend to follow earnings per share, so if you're interested in Faes Farma, you may well want to click here to check an interactive graph of its earnings per share history.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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.
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