David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We note that Zhejiang Starry Pharmaceutical Co.,Ltd. (SHSE:603520) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Zhejiang Starry PharmaceuticalLtd

What Is Zhejiang Starry PharmaceuticalLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2022 Zhejiang Starry PharmaceuticalLtd had CN¥2.12b of debt, an increase on CN¥1.96b, over one year. However, it does have CN¥783.6m in cash offsetting this, leading to net debt of about CN¥1.34b.

How Strong Is Zhejiang Starry PharmaceuticalLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zhejiang Starry PharmaceuticalLtd had liabilities of CN¥2.08b due within 12 months and liabilities of CN¥785.1m due beyond that. Offsetting this, it had CN¥783.6m in cash and CN¥798.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.29b.

Of course, Zhejiang Starry PharmaceuticalLtd has a market capitalization of CN¥7.10b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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

With a debt to EBITDA ratio of 2.3, Zhejiang Starry PharmaceuticalLtd uses debt artfully but responsibly. And the alluring interest cover (EBIT of 9.1 times interest expense) certainly does not do anything to dispel this impression. If Zhejiang Starry PharmaceuticalLtd can keep growing EBIT at last year's rate of 16% over the last year, then it will find its debt load easier to manage. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Zhejiang Starry PharmaceuticalLtd's ability to maintain a healthy balance sheet going forward. 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Zhejiang Starry PharmaceuticalLtd created free cash flow amounting to 9.4% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Zhejiang Starry PharmaceuticalLtd's interest cover was a real positive on this analysis, as was its EBIT growth rate. Having said that, its conversion of EBIT to free cash flow somewhat sensitizes us to potential future risks to the balance sheet. Considering this range of data points, we think Zhejiang Starry PharmaceuticalLtd is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. For instance, we've identified 2 warning signs for Zhejiang Starry PharmaceuticalLtd that 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.