David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 YiChang HEC ChangJiang Pharmaceutical Co., Ltd. (HKG:1558) 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 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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for YiChang HEC ChangJiang Pharmaceutical

What Is YiChang HEC ChangJiang Pharmaceutical's Debt?

The image below, which you can click on for greater detail, shows that at June 2022 YiChang HEC ChangJiang Pharmaceutical had debt of CN¥3.56b, up from CN¥3.09b in one year. However, it does have CN¥859.1m in cash offsetting this, leading to net debt of about CN¥2.70b.

How Strong Is YiChang HEC ChangJiang Pharmaceutical's Balance Sheet?

The latest balance sheet data shows that YiChang HEC ChangJiang Pharmaceutical had liabilities of CN¥3.97b due within a year, and liabilities of CN¥852.1m falling due after that. Offsetting this, it had CN¥859.1m in cash and CN¥765.3m in receivables that were due within 12 months. So its liabilities total CN¥3.20b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥3.85b, so it does suggest shareholders should keep an eye on YiChang HEC ChangJiang Pharmaceutical's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). 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).

While we wouldn't worry about YiChang HEC ChangJiang Pharmaceutical's net debt to EBITDA ratio of 4.6, we think its super-low interest cover of 1.1 times is a sign of high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. One redeeming factor for YiChang HEC ChangJiang Pharmaceutical is that it turned last year's EBIT loss into a gain of CN¥282m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if YiChang HEC ChangJiang 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, YiChang HEC ChangJiang Pharmaceutical burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, YiChang HEC ChangJiang Pharmaceutical's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. Overall, it seems to us that YiChang HEC ChangJiang Pharmaceutical's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - YiChang HEC ChangJiang Pharmaceutical has 1 warning sign we think you should be aware of.

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.