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. Importantly, Collegium Pharmaceutical, Inc. (NASDAQ:COLL) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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.

What Is Collegium Pharmaceutical’s Debt?

The chart below, which you can click on for greater detail, shows that Collegium Pharmaceutical had US$273.4m in debt in June 2021; about the same as the year before. However, it does have US$202.8m in cash offsetting this, leading to net debt of about US$70.6m.

How Strong Is Collegium Pharmaceutical’s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Collegium Pharmaceutical had liabilities of US$226.8m due within 12 months and liabilities of US$233.8m due beyond that. On the other hand, it had cash of US$202.8m and US$90.1m worth of receivables due within a year. So it has liabilities totalling US$167.8m more than its cash and near-term receivables, combined.

Collegium Pharmaceutical has a market capitalization of US$720.8m, 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.

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

While Collegium Pharmaceutical’s low debt to EBITDA ratio of 0.50 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.7 times last year does give us pause. So we’d recommend keeping a close eye on the impact financing costs are having on the business. Pleasingly, Collegium Pharmaceutical is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 462% gain in the last twelve months. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Collegium Pharmaceutical 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last two years, Collegium Pharmaceutical burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Based on what we’ve seen Collegium Pharmaceutical is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its EBIT growth rate. When we consider all the factors mentioned above, we do feel a bit cautious about Collegium Pharmaceutical’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. The balance sheet is clearly the area to focus on when you are analysing debt.