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. As with many other companies Palla Pharma Limited (ASX:PAL) makes use of debt. But the real question is whether this debt is making the company risky.
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Palla Pharma's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Palla Pharma had AU$22.9m of debt, an increase on AU$13.2m, over one year. However, it does have AU$2.46m in cash offsetting this, leading to net debt of about AU$20.5m.
A Look At Palla Pharma's Liabilities
The latest balance sheet data shows that Palla Pharma had liabilities of AU$14.5m due within a year, and liabilities of AU$33.5m falling due after that. On the other hand, it had cash of AU$2.46m and AU$16.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$29.1m.
Palla Pharma has a market capitalization of AU$81.1m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Palla Pharma's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Over 12 months, Palla Pharma reported revenue of AU$51m, which is a gain of 33%, although it did not report any earnings before interest and tax. With any luck the company will be able to grow its way to profitability.
While we can certainly savour Palla Pharma's tasty revenue growth, its negative earnings before interest and tax (EBIT) leaves a bitter aftertaste. Indeed, it lost AU$2.5m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. So we think its balance sheet is a little strained, though not beyond repair. However, it doesn't help that it burned through AU$18m of cash over the last year. So suffice it to say we consider the stock very risky. When we look at a riskier company, we like to check how their profits (or losses) are trending over time. Today, we're providing readers this interactive graph showing how Palla Pharma's profit, revenue, and operating cashflow have changed over the last few years.
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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