The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies Australian Pharmaceutical Industries Limited (ASX:API) makes use of debt. But the more important question is: how much risk is that debt creating?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for Australian Pharmaceutical Industries
What Is Australian Pharmaceutical Industries's Net Debt?
As you can see below, at the end of August 2019, Australian Pharmaceutical Industries had AU$228.8m of debt, up from AU$100.0m a year ago. Click the image for more detail. However, it also had AU$30.2m in cash, and so its net debt is AU$198.6m.
How Strong Is Australian Pharmaceutical Industries's Balance Sheet?
According to the last reported balance sheet, Australian Pharmaceutical Industries had liabilities of AU$887.5m due within 12 months, and liabilities of AU$255.4m due beyond 12 months. On the other hand, it had cash of AU$30.2m and AU$657.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$454.8m.
This deficit is considerable relative to its market capitalization of AU$687.1m, so it does suggest shareholders should keep an eye on Australian Pharmaceutical Industries's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).