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.' 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. As with many other companies Cipher Pharmaceuticals Inc. (TSE:CPH) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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.

See our latest analysis for Cipher Pharmaceuticals

What Is Cipher Pharmaceuticals's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Cipher Pharmaceuticals had US$13.6m of debt in June 2019, down from US$21.5m, one year before. On the flip side, it has US$9.25m in cash leading to net debt of about US$4.32m.

How Healthy Is Cipher Pharmaceuticals's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Cipher Pharmaceuticals had liabilities of US$17.4m due within 12 months and liabilities of US$8.45m due beyond that. On the other hand, it had cash of US$9.25m and US$7.83m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$8.79m.

This deficit isn't so bad because Cipher Pharmaceuticals is worth US$29.4m, and thus could probably raise enough capital to shore up 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.

With net debt sitting at just 0.60 times EBITDA, Cipher Pharmaceuticals is arguably pretty conservatively geared. And it boasts interest cover of 7.0 times, which is more than adequate. The modesty of its debt load may become crucial for Cipher Pharmaceuticals if management cannot prevent a repeat of the 66% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 Cipher Pharmaceuticals 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, 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. During the last three years, Cipher Pharmaceuticals produced sturdy free cash flow equating to 60% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Cipher Pharmaceuticals's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to convert EBIT to free cash flow isn't too shabby at all. We think that Cipher Pharmaceuticals's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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.