Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Shanghai Pharmaceuticals Holding Co., Ltd (SHSE:601607) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Shanghai Pharmaceuticals Holding

What Is Shanghai Pharmaceuticals Holding's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2022 Shanghai Pharmaceuticals Holding had debt of CN¥43.6b, up from CN¥37.6b in one year. However, because it has a cash reserve of CN¥36.6b, its net debt is less, at about CN¥7.00b.

How Healthy Is Shanghai Pharmaceuticals Holding's Balance Sheet?

According to the last reported balance sheet, Shanghai Pharmaceuticals Holding had liabilities of CN¥95.2b due within 12 months, and liabilities of CN¥12.4b due beyond 12 months. Offsetting these obligations, it had cash of CN¥36.6b as well as receivables valued at CN¥68.5b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.47b.

Of course, Shanghai Pharmaceuticals Holding has a market capitalization of CN¥60.3b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Shanghai Pharmaceuticals Holding has a low net debt to EBITDA ratio of only 0.78. And its EBIT covers its interest expense a whopping 10.6 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Shanghai Pharmaceuticals Holding grew its EBIT by 2.8% in the last year, making that debt load look even more manageable. 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 Shanghai Pharmaceuticals Holding 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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Shanghai Pharmaceuticals Holding's free cash flow amounted to 23% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

The good news is that Shanghai Pharmaceuticals Holding's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. It's also worth noting that Shanghai Pharmaceuticals Holding is in the Healthcare industry, which is often considered to be quite defensive. All these things considered, it appears that Shanghai Pharmaceuticals Holding can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Shanghai Pharmaceuticals Holding 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.