Australian Pharmaceutical Industries Ltd (ASX: API), the drug wholesaler, pharmacy and Priceline chain operator is aiming to double the number of its network of stores in the next three years.

The company released its half year results yesterday, 19th April 2012, with net profit back in the black after a horror 2012. Net profit came in at $18.3m compared to a loss of $35m for the previous corresponding period. Earnings per share were 3.8 cents, and the company declared a fully franked dividend of 1.5 cents.

That equates to a P/E of 10.8 and a dividend yield of 7.5 per cent, which looks attractive on face value. The company also has net tangible assets per share of 76.3 cents, compared to the current share price of around 40 cents.

However, there are several issues that mean the risks surrounding API out-weigh any potential reward.

Poor margins

First let’s start with the profit and loss statement. Those $18m of profits were derived from $1.6 billion in revenues, a net profit margin of just 1.1 per cent. Not much room for error there. Then we find out that those $18m of profits also includes additional insurance premium of $2.4m and other one-off adjustments, and the actual underlying net profit was just $11.8m, which represents a profit margin of just 0.7 per cent.

Too much debt

Next, let’s turn to the balance sheet. The company has $162m of short term debt, along with $10m of long term borrowings but just $23.6m of cash. That’s almost equivalent to the company’s current market capital of $190m. A rough and graphic picture is this: – for each share an investor buys at 40 cents, debt of 36 cents is attached to it.

The short term debt is rolled on a monthly basis, despite having a maturity date of May 2013. In other words, API’s bankers are closely monitoring its business.

Another factor that shows that API faces serious issues is that despite years of operating, and billions of dollars in revenues, it has just $5m in retained earnings.

Poor cash flow

Lastly, a look at the cash flow statement shows that the company received $21.3m in net cash from operating activities, after paying $13m in interest on its debts. Not much of a margin there either, and any tiny slip up could mean the company has to go cap-in-hand to its bankers.

Other issues

In the notes to the financial statements, there is a note titled “Going concern basis of accounting”. Directors had to make an assessment whether the business can still stay in business. They decided that the company could continue to generate sufficient cash flows to meet its debt covenants and funding requirements. While all financial reports are prepared on such a ‘going concern’ basis, the length and detail of that note suggests particular interest may have been taken by directors, auditors or both.

Whether they are right or not, only time will tell, but for investors, it’s a worrying sign when you see that in a company report.

The Foolish bottom line

As I mentioned in this article, sometimes you have to dig a little deeper to find out the true nature of a company’s actual profitability and value. Investing is as much as about avoiding the dogs as selecting good companies. API is one stock to give a miss.

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Motley Fool contributor Mike King doesn’t own shares in API. The Motley Fool’s purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Click here to be enlightened by The Motley Fool’s disclosure policy.

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