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. Importantly, Zhejiang Hisun Pharmaceutical Co., Ltd. (SHSE:600267) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

View our latest analysis for Zhejiang Hisun Pharmaceutical

What Is Zhejiang Hisun Pharmaceutical's Net Debt?

As you can see below, Zhejiang Hisun Pharmaceutical had CN¥7.65b of debt at March 2022, down from CN¥8.71b a year prior. On the flip side, it has CN¥1.56b in cash leading to net debt of about CN¥6.09b.

How Healthy Is Zhejiang Hisun Pharmaceutical's Balance Sheet?

We can see from the most recent balance sheet that Zhejiang Hisun Pharmaceutical had liabilities of CN¥8.60b falling due within a year, and liabilities of CN¥3.37b due beyond that. Offsetting these obligations, it had cash of CN¥1.56b as well as receivables valued at CN¥2.75b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥7.66b.

This deficit isn't so bad because Zhejiang Hisun Pharmaceutical is worth CN¥15.8b, and thus could probably raise enough capital to shore up 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.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Zhejiang Hisun Pharmaceutical's debt is 3.4 times its EBITDA, and its EBIT cover its interest expense 3.8 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Worse, Zhejiang Hisun Pharmaceutical's EBIT was down 26% 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. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Zhejiang Hisun Pharmaceutical's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last two years, Zhejiang Hisun Pharmaceutical recorded free cash flow worth a fulsome 94% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Neither Zhejiang Hisun Pharmaceutical's ability to grow its EBIT nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Taking the abovementioned factors together we do think Zhejiang Hisun Pharmaceutical's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. Be aware that Zhejiang Hisun Pharmaceutical is showing 4 warning signs in our investment analysis , you should know about...

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.