Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk. 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. We note that Hikma Pharmaceuticals PLC (LON:HIK) does have debt on its balance sheet. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Hikma Pharmaceuticals's Debt?
The image below, which you can click on for greater detail, shows that Hikma Pharmaceuticals had debt of US$628.0m at the end of June 2019, a reduction from US$721.0m over a year. However, because it has a cash reserve of US$344.0m, its net debt is less, at about US$284.0m.
How Strong Is Hikma Pharmaceuticals's Balance Sheet?
According to the last reported balance sheet, Hikma Pharmaceuticals had liabilities of US$1.32b due within 12 months, and liabilities of US$438.0m due beyond 12 months. Offsetting this, it had US$344.0m in cash and US$687.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$731.0m.
Of course, Hikma Pharmaceuticals has a market capitalization of US$6.16b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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).
Hikma Pharmaceuticals's net debt is only 0.51 times its EBITDA. And its EBIT covers its interest expense a whopping 12.9 times over. So we're pretty relaxed about its super-conservative use of debt. Another good sign is that Hikma Pharmaceuticals has been able to increase its EBIT by 21% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Hikma Pharmaceuticals's ability to maintain a healthy balance sheet going forward. 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 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, Hikma Pharmaceuticals produced sturdy free cash flow equating to 64% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Hikma Pharmaceuticals's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. Zooming out, Hikma Pharmaceuticals seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. Another factor that would give us confidence in Hikma Pharmaceuticals would be if insiders have been buying shares: if you're conscious of that signal too, you can find out instantly by clicking this link.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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