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, Lushang Freda Pharmaceutical Co.,Ltd. (SHSE:600223) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 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.

What Is Lushang Freda PharmaceuticalLtd's Debt?

The image below, which you can click on for greater detail, shows that Lushang Freda PharmaceuticalLtd had debt of CN¥3.46b at the end of September 2023, a reduction from CN¥7.11b over a year. However, because it has a cash reserve of CN¥1.58b, its net debt is less, at about CN¥1.89b.

A Look At Lushang Freda PharmaceuticalLtd's Liabilities

We can see from the most recent balance sheet that Lushang Freda PharmaceuticalLtd had liabilities of CN¥5.12b falling due within a year, and liabilities of CN¥1.09b due beyond that. Offsetting this, it had CN¥1.58b in cash and CN¥2.55b in receivables that were due within 12 months. So its liabilities total CN¥2.08b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Lushang Freda PharmaceuticalLtd is worth CN¥8.61b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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).

Strangely Lushang Freda PharmaceuticalLtd has a sky high EBITDA ratio of 5.1, implying high debt, but a strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Shareholders should be aware that Lushang Freda PharmaceuticalLtd's EBIT was down 57% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Lushang Freda PharmaceuticalLtd can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Lushang Freda PharmaceuticalLtd actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

We weren't impressed with Lushang Freda PharmaceuticalLtd's net debt to EBITDA, and its EBIT growth rate made us cautious. But like a ballerina ending on a perfect pirouette, it has not trouble covering its interest expense with its EBIT. Looking at all this data makes us feel a little cautious about Lushang Freda PharmaceuticalLtd's debt levels. 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. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Lushang Freda PharmaceuticalLtd that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.