Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We note that Tonghua Dongbao Pharmaceutical Co., Ltd. (SHSE:600867) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Tonghua Dongbao Pharmaceutical's Debt?
As you can see below, at the end of September 2023, Tonghua Dongbao Pharmaceutical had CN¥150.0m of debt, up from CN¥2.65m a year ago. Click the image for more detail. But on the other hand it also has CN¥716.8m in cash, leading to a CN¥566.8m net cash position.
How Healthy Is Tonghua Dongbao Pharmaceutical's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Tonghua Dongbao Pharmaceutical had liabilities of CN¥334.2m due within 12 months and liabilities of CN¥35.0m due beyond that. Offsetting these obligations, it had cash of CN¥716.8m as well as receivables valued at CN¥765.8m due within 12 months. So it can boast CN¥1.11b more liquid assets than total liabilities.
This surplus suggests that Tonghua Dongbao Pharmaceutical has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Tonghua Dongbao Pharmaceutical has more cash than debt is arguably a good indication that it can manage its debt safely.
In addition to that, we're happy to report that Tonghua Dongbao Pharmaceutical has boosted its EBIT by 55%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Tonghua Dongbao Pharmaceutical 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Tonghua Dongbao Pharmaceutical has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Looking at the most recent three years, Tonghua Dongbao Pharmaceutical recorded free cash flow of 31% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Summing Up
While we empathize with investors who find debt concerning, you should keep in mind that Tonghua Dongbao Pharmaceutical has net cash of CN¥566.8m, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 55% over the last year. So is Tonghua Dongbao Pharmaceutical's debt a risk? It doesn't seem so to us. 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. Case in point: We've spotted 2 warning signs for Tonghua Dongbao Pharmaceutical you should be aware of.
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.