Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We note that Aarti Drugs Limited (NSE:AARTIDRUGS) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

Check out our latest analysis for Aarti Drugs

How Much Debt Does Aarti Drugs Carry?

You can click the graphic below for the historical numbers, but it shows that Aarti Drugs had ₹5.07b of debt in March 2019, down from ₹5.46b, one year before. However, it also had ₹144.8m in cash, and so its net debt is ₹4.93b.

How Strong Is Aarti Drugs's Balance Sheet?

We can see from the most recent balance sheet that Aarti Drugs had liabilities of ₹5.91b falling due within a year, and liabilities of ₹3.28b due beyond that. Offsetting these obligations, it had cash of ₹144.8m as well as receivables valued at ₹4.65b due within 12 months. So it has liabilities totalling ₹4.40b more than its cash and near-term receivables, combined.

Aarti Drugs has a market capitalization of ₹10.2b, 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.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Aarti Drugs has net debt worth 2.4 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 4.3 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Unfortunately, Aarti Drugs saw its EBIT slide 4.9% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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 Aarti Drugs 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Aarti Drugs's free cash flow amounted to 27% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

While Aarti Drugs's EBIT growth rate makes us cautious about it, its track record of converting EBIT to free cash flow is no better. At least its net debt to EBITDA gives us reason to be optimistic. When we consider all the factors discussed, it seems to us that Aarti Drugs is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.

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 editorial-team@simplywallst.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. Thank you for reading.