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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Grand Pharmaceutical Group Limited (HKG:512) makes use of debt. But is this debt a concern to shareholders?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Grand Pharmaceutical Group's Net Debt?

The image below, which you can click on for greater detail, shows that Grand Pharmaceutical Group had debt of HK$3.33b at the end of December 2023, a reduction from HK$4.43b over a year. However, it also had HK$3.27b in cash, and so its net debt is HK$56.2m.

How Healthy Is Grand Pharmaceutical Group's Balance Sheet?

We can see from the most recent balance sheet that Grand Pharmaceutical Group had liabilities of HK$5.73b falling due within a year, and liabilities of HK$1.51b due beyond that. Offsetting this, it had HK$3.27b in cash and HK$2.32b in receivables that were due within 12 months. So it has liabilities totalling HK$1.65b more than its cash and near-term receivables, combined.

Since publicly traded Grand Pharmaceutical Group shares are worth a total of HK$16.6b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. But either way, Grand Pharmaceutical Group has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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

Grand Pharmaceutical Group has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.019 and EBIT of 12.7 times the interest expense. So relative to past earnings, the debt load seems trivial. But the bad news is that Grand Pharmaceutical Group has seen its EBIT plunge 12% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Grand Pharmaceutical Group 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Grand Pharmaceutical Group recorded free cash flow of 29% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Grand Pharmaceutical Group's interest cover was a real positive on this analysis, as was its net debt to EBITDA. On the other hand, its EBIT growth rate makes us a little less comfortable about its debt. Considering this range of data points, we think Grand Pharmaceutical Group is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Grand Pharmaceutical Group is showing 1 warning sign in our investment analysis , you should know about...

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.