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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Guangzhou Baiyunshan Pharmaceutical Holdings Company Limited (HKG:874) does carry 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Guangzhou Baiyunshan Pharmaceutical Holdings

What Is Guangzhou Baiyunshan Pharmaceutical Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2022 Guangzhou Baiyunshan Pharmaceutical Holdings had debt of CN¥10.7b, up from CN¥10.1b in one year. However, its balance sheet shows it holds CN¥23.6b in cash, so it actually has CN¥12.9b net cash.

How Strong Is Guangzhou Baiyunshan Pharmaceutical Holdings' Balance Sheet?

According to the last reported balance sheet, Guangzhou Baiyunshan Pharmaceutical Holdings had liabilities of CN¥31.2b due within 12 months, and liabilities of CN¥2.64b due beyond 12 months. Offsetting these obligations, it had cash of CN¥23.6b as well as receivables valued at CN¥19.9b due within 12 months. So it can boast CN¥9.61b more liquid assets than total liabilities.

This surplus suggests that Guangzhou Baiyunshan Pharmaceutical Holdings is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Succinctly put, Guangzhou Baiyunshan Pharmaceutical Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!

And we also note warmly that Guangzhou Baiyunshan Pharmaceutical Holdings grew its EBIT by 20% last year, making its debt load easier to handle. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Guangzhou Baiyunshan Pharmaceutical Holdings's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Guangzhou Baiyunshan Pharmaceutical Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Guangzhou Baiyunshan Pharmaceutical Holdings recorded free cash flow worth a fulsome 96% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Summing up

While it is always sensible to investigate a company's debt, in this case Guangzhou Baiyunshan Pharmaceutical Holdings has CN¥12.9b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 96% of that EBIT to free cash flow, bringing in CN¥3.6b. So we don't think Guangzhou Baiyunshan Pharmaceutical Holdings's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Guangzhou Baiyunshan Pharmaceutical Holdings , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.