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, Zhejiang Starry Pharmaceutical Co.,Ltd. (SHSE:603520) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Zhejiang Starry PharmaceuticalLtd

What Is Zhejiang Starry PharmaceuticalLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2023 Zhejiang Starry PharmaceuticalLtd had CN¥3.01b of debt, an increase on CN¥2.12b, over one year. However, it does have CN¥778.7m in cash offsetting this, leading to net debt of about CN¥2.24b.

A Look At Zhejiang Starry PharmaceuticalLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that Zhejiang Starry PharmaceuticalLtd had liabilities of CN¥2.87b due within 12 months and liabilities of CN¥872.6m due beyond that. Offsetting this, it had CN¥778.7m in cash and CN¥715.4m in receivables that were due within 12 months. So its liabilities total CN¥2.25b more than the combination of its cash and short-term receivables.

Zhejiang Starry PharmaceuticalLtd has a market capitalization of CN¥5.16b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Zhejiang Starry PharmaceuticalLtd shareholders face the double whammy of a high net debt to EBITDA ratio (9.4), and fairly weak interest coverage, since EBIT is just 0.84 times the interest expense. The debt burden here is substantial. Worse, Zhejiang Starry PharmaceuticalLtd's EBIT was down 82% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 Zhejiang Starry PharmaceuticalLtd'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, 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. During the last three years, Zhejiang Starry PharmaceuticalLtd 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

To be frank both Zhejiang Starry PharmaceuticalLtd's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least its level of total liabilities is not so bad. After considering the datapoints discussed, we think Zhejiang Starry PharmaceuticalLtd has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Zhejiang Starry PharmaceuticalLtd , and understanding them should be part of your investment process.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.