Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Alkem Laboratories Limited (NSE:ALKEM) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
The image below, which you can click on for greater detail, shows that Alkem Laboratories had debt of ₹9.38b at the end of March 2019, a reduction from ₹9.98b over a year. On the flip side, it has ₹6.54b in cash leading to net debt of about ₹2.84b.
NSEI:ALKEM Historical Debt, September 4th 2019
How Healthy Is Alkem Laboratories's Balance Sheet?
The latest balance sheet data shows that Alkem Laboratories had liabilities of ₹21.9b due within a year, and liabilities of ₹4.46b falling due after that. Offsetting these obligations, it had cash of ₹6.54b as well as receivables valued at ₹14.1b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹5.73b.
Given Alkem Laboratories has a market capitalization of ₹217.2b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Carrying virtually no net debt, Alkem Laboratories has a very light debt load indeed.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Alkem Laboratories's net debt is only 0.24 times its EBITDA. And its EBIT covers its interest expense a whopping 804 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that Alkem Laboratories saw its EBIT decline by 2.7% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Alkem Laboratories'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 it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Alkem Laboratories actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Our View
When it comes to the balance sheet, the standout positive for Alkem Laboratories was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. In particular, conversion of EBIT to free cash flow gives us cold feet. When we consider all the factors mentioned above, we do feel a bit cautious about Alkem Laboratories's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. We'd be motivated to research the stock further if we found out that Alkem Laboratories 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.
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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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.
