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.' 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. We can see that Guizhou Xinbang Pharmaceutical Co., Ltd. (SZSE:002390) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Guizhou Xinbang Pharmaceutical's Net Debt?
The image below, which you can click on for greater detail, shows that Guizhou Xinbang Pharmaceutical had debt of CN¥809.9m at the end of December 2023, a reduction from CN¥1.37b over a year. However, it also had CN¥806.0m in cash, and so its net debt is CN¥3.88m.
A Look At Guizhou Xinbang Pharmaceutical's Liabilities
The latest balance sheet data shows that Guizhou Xinbang Pharmaceutical had liabilities of CN¥2.06b due within a year, and liabilities of CN¥44.3m falling due after that. Offsetting this, it had CN¥806.0m in cash and CN¥3.36b in receivables that were due within 12 months. So it can boast CN¥2.06b more liquid assets than total liabilities.
This surplus suggests that Guizhou Xinbang Pharmaceutical is using debt in a way that is appears to be both safe and conservative. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Carrying virtually no net debt, Guizhou Xinbang Pharmaceutical has a very light debt load indeed.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
With debt at a measly 0.0063 times EBITDA and EBIT covering interest a whopping 22.0 times, it's clear that Guizhou Xinbang Pharmaceutical is not a desperate borrower. So relative to past earnings, the debt load seems trivial. And we also note warmly that Guizhou Xinbang Pharmaceutical grew its EBIT by 16% last year, making its debt load easier to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Guizhou Xinbang Pharmaceutical's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Guizhou Xinbang Pharmaceutical actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Our View
Happily, Guizhou Xinbang Pharmaceutical's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! We think Guizhou Xinbang Pharmaceutical is no more beholden to its lenders, than the birds are to birdwatchers. To our minds it has a healthy happy balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Guizhou Xinbang Pharmaceutical you should know about.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.