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 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 Sino Biopharmaceutical Limited (HKG:1177) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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.

View our latest analysis for Sino Biopharmaceutical

What Is Sino Biopharmaceutical's Net Debt?

The image below, which you can click on for greater detail, shows that Sino Biopharmaceutical had debt of CN¥11.6b at the end of June 2022, a reduction from CN¥13.3b over a year. However, it does have CN¥15.7b in cash offsetting this, leading to net cash of CN¥4.06b.

A Look At Sino Biopharmaceutical's Liabilities

Zooming in on the latest balance sheet data, we can see that Sino Biopharmaceutical had liabilities of CN¥16.3b due within 12 months and liabilities of CN¥9.92b due beyond that. On the other hand, it had cash of CN¥15.7b and CN¥5.35b worth of receivables due within a year. So its liabilities total CN¥5.16b more than the combination of its cash and short-term receivables.

Of course, Sino Biopharmaceutical has a market capitalization of CN¥61.5b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Sino Biopharmaceutical boasts net cash, so it's fair to say it does not have a heavy debt load!

On the other hand, Sino Biopharmaceutical saw its EBIT drop by 6.0% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. 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 Sino Biopharmaceutical 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Sino Biopharmaceutical 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. During the last three years, Sino Biopharmaceutical generated free cash flow amounting to a very robust 80% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Sino Biopharmaceutical has CN¥4.06b in net cash. The cherry on top was that in converted 80% of that EBIT to free cash flow, bringing in CN¥5.1b. So we don't think Sino Biopharmaceutical's use of debt is risky. We'd be motivated to research the stock further if we found out that Sino Biopharmaceutical insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.