Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, China Traditional Chinese Medicine Holdings Co. Limited (HKG:570) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for China Traditional Chinese Medicine Holdings

What Is China Traditional Chinese Medicine Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2022 China Traditional Chinese Medicine Holdings had debt of CN¥7.33b, up from CN¥6.44b in one year. On the flip side, it has CN¥6.14b in cash leading to net debt of about CN¥1.18b.

How Strong Is China Traditional Chinese Medicine Holdings' Balance Sheet?

We can see from the most recent balance sheet that China Traditional Chinese Medicine Holdings had liabilities of CN¥12.6b falling due within a year, and liabilities of CN¥2.64b due beyond that. On the other hand, it had cash of CN¥6.14b and CN¥7.35b worth of receivables due within a year. So its liabilities total CN¥1.70b more than the combination of its cash and short-term receivables.

Of course, China Traditional Chinese Medicine Holdings has a market capitalization of CN¥15.0b, 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.

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). 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).

China Traditional Chinese Medicine Holdings has a low net debt to EBITDA ratio of only 0.43. And its EBIT easily covers its interest expense, being 13.4 times the size. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for China Traditional Chinese Medicine Holdings if management cannot prevent a repeat of the 27% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 China Traditional Chinese Medicine Holdings 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. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, China Traditional Chinese Medicine Holdings reported free cash flow worth 15% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

We feel some trepidation about China Traditional Chinese Medicine Holdings's difficulty EBIT growth rate, but we've got positives to focus on, too. To wit both its interest cover and net debt to EBITDA were encouraging signs. Looking at all the angles mentioned above, it does seem to us that China Traditional Chinese Medicine Holdings is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.

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.